UNITED STATES



SECURITIES AND EXCHANGE COMMISSION



Washington, D.C. 20549



FORM 10Q



| | x | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE
SECURITIES EXCHANGE ACT OF 1934
| | - | ---------------------------------------------------------------------------------------



For the quarterly period ended June 30, 2012



or



| |  ̈ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
| | - | ----------------------------------------------------------------------------------------



For the transition period from ________ to ________



Commission File Number: 2-88927





|FIRST KEYSTONE CORPORATION                            
|------------------------------------------------------
|(Exact name of registrant as specified in its charter)
|                                                      
|Pennsylvania                                          
|(State
or other jurisdiction of                       
|incorporation or organization)                        
|                                                      
|                                                      
|111 West Front Street, Berwick, PA                    
|(Address
of principal executive offices)              



Registrant’s telephone number, including area code: (570)
752-3671



Indicate by check mark whether the registrant (1) has filed
all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or
for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements
for the past 90 days.

Yes x     No
 ̈



Indicate by check mark whether the registrant has submitted
electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant
to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the
registrant was required to submit and post such files).

Yes x     No  ̈



Indicate by check mark whether the registrant is a large accelerated
filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated
filer,” “accelerated filer,” and “small reporting company” in Rule 12b-2 of the Exchange Act.



| | Large accelerated filer |  ̈ | Accelerated filer         | x
| | ----------------------- | - | ------------------------- | -
| | Non-accelerated filer   |  ̈ | Smaller reporting company |  ̈



Indicate by check mark whether the registrant is a shell company
(as defined in Rule 12b-2 of the Act).

Yes  ̈     No x



Indicate the number of shares outstanding of each of the issuer’s
classes of common stock, as of the latest practical date:



Common Stock, $2 Par Value, 5,456,193 shares as of August 8,
2012.











PART I - FINANCIAL INFORMATION



Item 1. Financial Statements



FIRST KEYSTONE CORPORATION AND SUBSIDIARY

CONSOLIDATED BALANCE SHEETS



|(Amounts in thousands)                                                                                                                         |  | June 30,    |         |   | December 31, |  
|---------------------------------------------------------------------------------------------------------------------------------------------- |  | ----------- | ------- | - | ------------ | -
|                                                                                                                                               |  | 2012        |         |   | 2011         |  
|ASSETS                                                                                                                                         |  | (Unaudited) |         |   |              |  
|Cash and due from banks                                                                                                                        |  | $           | 8,462   |   |              | $
|Interest-bearing deposits in other banks                                                                                                       |  |             | 2,967   |   |              |  
|Total cash and cash equivalents                                                                                                                |  |             | 11,429  |   |              |  
|Investment securities available-for-sale                                                                                                       |  |             | 308,532 |   |              |  
|Investment securities held-to-maturity (estimated fair value of $2,646 in 2012 and $2,666 in 2011)                                             |  |             | 2,591   |   |              |  
|Restricted securities at cost - available-for-sale                                                                                             |  |             | 4,892   |   |              |  
|Loans, net of unearned income                                                                                                                  |  |             | 419,638 |   |              |  
|Allowance for loan losses                                                                                                                      |  |             | (5,824  | ) |              |  
|Net loans                                                                                                                                      |  |             | 413,814 |   |              |  
|Premises and equipment, net                                                                                                                    |  |             | 16,088  |   |              |  
|Accrued interest receivable                                                                                                                    |  |             | 4,104   |   |              |  
|Cash surrender value of bank owned life insurance                                                                                              |  |             | 19,512  |   |              |  
|Investment in real estate ventures                                                                                                             |  |             | 1,382   |   |              |  
|Goodwill                                                                                                                                       |  |             | 19,133  |   |              |  
|Core deposit intangible                                                                                                                        |  |             | 810     |   |              |  
|Prepaid FDIC insurance                                                                                                                         |  |             | 1,209   |   |              |  
|Foreclosed assets held for resale                                                                                                              |  |             | 1,086   |   |              |  
|Deferred income taxes                                                                                                                          |  |             | 47      |   |              |  
|Other assets                                                                                                                                   |  |             | 1,579   |   |              |  
|TOTAL ASSETS                                                                                                                                   |  | $           | 806,208 |   |              | $
|                                                                                                                                               |  |             |         |   |              |  
|LIABILITIES                                                                                                                                    |  |             |         |   |              |  
|Deposits:                                                                                                                                      |  |             |         |   |              |  
|Non-interest bearing                                                                                                                           |  | $           | 85,172  |   |              | $
|Interest bearing                                                                                                                               |  |             | 525,446 |   |              |  
|Total Deposits                                                                                                                                 |  |             | 610,618 |   |              |  
|Short-term borrowings                                                                                                                          |  |             | 39,658  |   |              |  
|Long-term borrowings                                                                                                                           |  |             | 50,557  |   |              |  
|Accrued interest and other expenses                                                                                                            |  |             | 2,524   |   |              |  
|Deferred income taxes                                                                                                                          |  |             | 3,752   |   |              |  
|Other liabilities                                                                                                                              |  |             | 483     |   |              |  
|TOTAL LIABILITIES                                                                                                                              |  | $           | 707,592 |   |              | $
|                                                                                                                                               |  |             |         |   |              |  
|STOCKHOLDERS’ EQUITY                                                                                                                           |  |             |         |   |              |  
|Preferred stock, par value $2.00 per share; authorized 1,000,000 shares in 2012; issued 0 in 2012                                              |  | $           | 0       |   |              | $
|Common stock, par value $2.00 per share; authorized 20,000,000 shares in 2012 and 10,000,000 shares in 2011; issued 5,687,767 in 2012 and 2011 |  |             | 11,375  |   |              |  
|Surplus                                                                                                                                        |  |             | 30,142  |   |              |  
|Retained earnings                                                                                                                              |  |             | 52,383  |   |              |  
|Accumulated other comprehensive income                                                                                                         |  |             | 10,758  |   |              |  
|Treasury stock, at cost, 241,730 shares in 2012 and 242,517 shares in 2011                                                                     |  |             | (6,042  | ) |              |  
|                                                                                                                                               |  |             |         |   |              |  
|TOTAL STOCKHOLDERS’ EQUITY                                                                                                                     |  |             | 98,616  |   |              |  
|TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                     |  | $           | 806,208 |   |              | $



See accompanying notes to consolidated financial statements.





1







FIRST KEYSTONE CORPORATION AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF INCOME

FOR THE THREE MONTHS ENDED JUNE 30, 2012
AND 2011

(Unaudited)



(Amounts in thousands, except per share data)

|                                                      |  | 2012 |       |  | 2011 |  
|----------------------------------------------------- |  | ---- | ----- |  | ---- | -
|INTEREST INCOME                                       |  |      |       |  |      |  
|Interest and fees on loans                            |  | $    | 5,628 |  |      | $
|Interest and dividend income on investment securities |  |      | 3,213 |  |      |  
|Interest on deposits in banks                         |  |      | 0     |  |      |  
|Total interest income                                 |  | $    | 8,841 |  |      | $
|                                                      |  |      |       |  |      |  
|INTEREST EXPENSE                                      |  |      |       |  |      |  
|Interest on deposits                                  |  | $    | 1,158 |  |      | $
|Interest on short-term borrowings                     |  |      | 30    |  |      |  
|Interest on long-term borrowings                      |  |      | 527   |  |      |  
|Total interest expense                                |  | $    | 1,715 |  |      | $
|                                                      |  |      |       |  |      |  
|Net interest income                                   |  | $    | 7,126 |  |      | $
|Provision for loan losses                             |  |      | 400   |  |      |  
|Net interest income after provision for loan losses   |  | $    | 6,726 |  |      | $
|                                                      |  |      |       |  |      |  
|NON-INTEREST INCOME                                   |  |      |       |  |      |  
|Trust department                                      |  | $    | 178   |  |      | $
|Service charges and fees                              |  |      | 286   |  |      |  
|Bank owned life insurance income                      |  |      | 184   |  |      |  
|ATM fees and debit card income                        |  |      | 248   |  |      |  
|Gains on sale of mortgage loans                       |  |      | 246   |  |      |  
|Investment securities gains (losses) - net            |  |      | 977   |  |      |  
|Other                                                 |  |      | 74    |  |      |  
|Total non-interest income                             |  | $    | 2,193 |  |      | $
|                                                      |  |      |       |  |      |  
|NON-INTEREST EXPENSE                                  |  |      |       |  |      |  
|Salaries and employee benefits                        |  | $    | 2,570 |  |      | $
|Occupancy, net                                        |  |      | 329   |  |      |  
|Furniture and equipment                               |  |      | 132   |  |      |  
|Computer expense                                      |  |      | 271   |  |      |  
|Professional services                                 |  |      | 170   |  |      |  
|State shares tax                                      |  |      | 191   |  |      |  
|FDIC insurance                                        |  |      | 129   |  |      |  
|ATM and debit card fees                               |  |      | 117   |  |      |  
|FHLB prepayment penalties                             |  |      | 811   |  |      |  
|Other                                                 |  |      | 1,087 |  |      |  
|Total non-interest expense                            |  | $    | 5,807 |  |      | $
|                                                      |  |      |       |  |      |  
|Income before income tax expense                      |  | $    | 3,112 |  |      | $
|Income tax expense                                    |  |      | 534   |  |      |  
|NET INCOME                                            |  | $    | 2,578 |  |      | $
|                                                      |  |      |       |  |      |  
|PER SHARE DATA                                        |  |      |       |  |      |  
|Net Income Per Share:                                 |  |      |       |  |      |  
|Basic                                                 |  | $    | .47   |  |      | $
|Diluted                                               |  |      | .47   |  |      |  
|Cash dividends per share                              |  |      | .25   |  |      |  



See accompanying notes to consolidated financial statements.





2









FIRST KEYSTONE CORPORATION AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF INCOME

FOR THE SIX MONTHS ENDED JUNE 30, 2012 AND
2011

(Unaudited)



(Amounts in thousands, except per share data)



|                                                      |  | 2012 |        |  | 2011 |  
|----------------------------------------------------- |  | ---- | ------ |  | ---- | -
|INTEREST INCOME                                       |  |      |        |  |      |  
|Interest and fees on loans                            |  | $    | 11,299 |  |      | $
|Interest and dividend income on investment securities |  |      | 6,469  |  |      |  
|Interest on deposits in banks                         |  |      | 0      |  |      |  
|Total interest income                                 |  | $    | 17,768 |  |      | $
|                                                      |  |      |        |  |      |  
|INTEREST EXPENSE                                      |  |      |        |  |      |  
|Interest on deposits                                  |  | $    | 2,463  |  |      | $
|Interest on short-term borrowings                     |  |      | 59     |  |      |  
|Interest on long-term borrowings                      |  |      | 1,100  |  |      |  
|Total interest expense                                |  | $    | 3,622  |  |      | $
|                                                      |  |      |        |  |      |  
|Net interest income                                   |  | $    | 14,146 |  |      | $
|Provision for loan losses                             |  |      | 800    |  |      |  
|Net interest income after provision for loan losses   |  | $    | 13,346 |  |      | $
|                                                      |  |      |        |  |      |  
|NON-INTEREST INCOME                                   |  |      |        |  |      |  
|Trust department                                      |  | $    | 368    |  |      | $
|Service charges and fees                              |  |      | 572    |  |      |  
|Bank owned life insurance income                      |  |      | 367    |  |      |  
|ATM fees and debit card income                        |  |      | 491    |  |      |  
|Gains on sale of mortgage loans                       |  |      | 406    |  |      |  
|Investment securities gains (losses) - net            |  |      | 1,007  |  |      |  
|Other                                                 |  |      | 186    |  |      |  
|Total non-interest income                             |  | $    | 3,397  |  |      | $
|                                                      |  |      |        |  |      |  
|NON-INTEREST EXPENSE                                  |  |      |        |  |      |  
|Salaries and employee benefits                        |  | $    | 5,192  |  |      | $
|Occupancy, net                                        |  |      | 674    |  |      |  
|Furniture and equipment                               |  |      | 243    |  |      |  
|Computer expense                                      |  |      | 523    |  |      |  
|Professional services                                 |  |      | 340    |  |      |  
|State shares tax                                      |  |      | 371    |  |      |  
|FDIC insurance                                        |  |      | 255    |  |      |  
|ATM and debit card fees                               |  |      | 227    |  |      |  
|FHLB prepayment penalties                             |  |      | 811    |  |      |  
|Other                                                 |  |      | 1,756  |  |      |  
|Total non-interest expense                            |  | $    | 10,392 |  |      | $
|                                                      |  |      |        |  |      |  
|Income before income tax expense                      |  | $    | 6,351  |  |      | $
|Income tax expense                                    |  |      | 1,117  |  |      |  
|NET INCOME                                            |  | $    | 5,234  |  |      | $
|                                                      |  |      |        |  |      |  
|PER SHARE DATA                                        |  |      |        |  |      |  
|Net Income Per Share:                                 |  |      |        |  |      |  
|Basic                                                 |  | $    | .96    |  |      | $
|Diluted                                               |  |      | .96    |  |      |  
|Cash dividends per share                              |  |      | .50    |  |      |  



See accompanying notes to consolidated financial statements.





3







FIRST KEYSTONE CORPORATION AND SUBSIDIARY

CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS’
EQUITY

(Unaudited)



(Amounts in thousands, except shares)

|                                                                                                                                            |  |                  |           |  |        |   |        |         |  |   |          |   |  |               |       |  | Accumulated       |   |        |       |  |   |        |  
|------------------------------------------------------------------------------------------------------------------------------------------- |  | ---------------- | --------- |  | ------ | - | ------ | ------- |  | - | -------- | - |  | ------------- | ----- |  | ----------------- | - | ------ | ----- |  | - | ------ | -
|                                                                                                                                            |  |                  |           |  |        |   |        |         |  |   | Compre-  |   |  |               |       |  | Other             |   |        |       |  |   |        |  
|                                                                                                                                            |  | Common
    Stock |           |  |        |   |        | hensive |  |   | Retained |   |  | Comprehensive |       |  | Treasury          |   |        |       | 
|                                                                                                                                            |  | Shares           |           |  | Amount |   |        | Surplus |  |   | Income   |   |  | Earnings      |       |  | Income
    (Loss) |   |        | Stock |  |   | Total  |  
|Balance at December 31, 2011                                                                                                                |  |                  | 5,687,767 |  |        | $ | 11,375 |         |  | $ | 30,157   |   |  |               |       |  |                   | $ | 49,872 |       |  | $ | 7,757  |  
|Comprehensive Income:                                                                                                                       |  |                  |           |  |        |   |        |         |  |   |          |   |  |               |       |  |                   |   |        |       |  |   |        |  
|Net Income                                                                                                                                  |  |                  |           |  |        |   |        |         |  |   |          |   |  | $             | 5,234 |  |                   |   | 5,234  |       |  |   |        |  
|Change
    in net unrealized gains (losses) on investment securities available-for-sale, net of reclassification adjustment and tax effects |  |                  |           |  |        |   |        |         |  |   |          |   |  |               | 3,001 |  |                   |   |        |       |  |   | 3,001  |  
|Total comprehensive income                                                                                                                  |  |                  |           |  |        |   |        |         |  |   |          |   |  | $             | 8,235 |  |                   |   |        |       |  |   |        |  
|Issuance
    of 787 shares of treasury stock upon exercise of employee stock options                                                        |  |                  |           |  |        |   |        |         |  |   | (15      | ) |  |               |       |  |                   |   |        |       |  |   |        |  
|Cash dividends - $.50 per share                                                                                                             |  |                  |           |  |        |   |        |         |  |   |          |   |  |               |       |  |                   |   | (2,723 | )     |  |   |        |  
|Balance at June 30, 2012                                                                                                                    |  |                  | 5,687,767 |  |        | $ | 11,375 |         |  | $ | 30,142   |   |  |               |       |  |                   | $ | 52,383 |       |  | $ | 10,758 |  
|                                                                                                                                            |  |                  |           |  |        |   |        |         |  |   |          |   |  |               |       |  |                   |   |        |       |  |   |        |  
|Balance at December 31, 2010                                                                                                                |  |                  | 5,687,767 |  |        | $ | 11,375 |         |  | $ | 30,175   |   |  |               |       |  |                   | $ | 45,246 |       |  | $ | (1,633 | )
|Comprehensive Income:                                                                                                                       |  |                  |           |  |        |   |        |         |  |   |          |   |  |               |       |  |                   |   |        |       |  |   |        |  
|Net Income                                                                                                                                  |  |                  |           |  |        |   |        |         |  |   |          |   |  | $             | 5,039 |  |                   |   | 5,039  |       |  |   |        |  
|Change
    in unrealized gains (losses) on investment securities available-for sale, net of reclassification adjustment and tax effects     |  |                  |           |  |        |   |        |         |  |   |          |   |  |               | 2,848 |  |                   |   |        |       |  |   | 2,848  |  
|Total
    comprehensive income                                                                                                              |  |                  |           |  |        |   |        |         |  |   |          |   |  | $             | 7,887 |  |                   |   |        |       |  |   |        |  
|Issuance
    of 815 shares of treasury stock upon exercise of employee stock options                                                        |  |                  |           |  |        |   |        |         |  |   | (15      | ) |  |               |       |  |                   |   |        |       |  |   |        |  
|Cash dividends - $.48 per share                                                                                                             |  |                  |           |  |        |   |        |         |  |   |          |   |  |               |       |  |                   |   | (2,613 | )     |  |   |        |  
|Balance at June 30, 2011                                                                                                                    |  |                  | 5,687,767 |  |        | $ | 11,375 |         |  | $ | 30,160   |   |  |               |       |  |                   | $ | 47,672 |       |  | $ | 1,215  |  





CONSOLIDATED STATEMENTS OF COMPREHENSIVE
INCOME

(Unaudited)



|(Amounts in thousands)                                                                             |  | Three Months Ended |       |   | Six Months Ended |  
|-------------------------------------------------------------------------------------------------- |  | ------------------ | ----- | - | ---------------- | -
|                                                                                                   |  | June 30,           |       |   | June 30,         |  
|                                                                                                   |  | 2012               |       |   | 2011             |  
|Net Income                                                                                         |  | $                  | 2,578 |   |                  | $
|Other comprehensive income (losses):                                                               |  |                    |       |   |                  |  
|Unrealized holding gains on
    available-for-sale investment securities arising during the period |  |                    | 3,670 |   |                  |  
|Less reclassification adjustment for net gains (losses) realized in income                         |  |                    | 977   |   |                  |  
|Change in unrealized gains before tax effect                                                       |  |                    | 2,693 |   |                  |  
|Tax effects                                                                                        |  |                    | (911  | ) |                  |  
|Net change in unrealized gains                                                                     |  |                    | 1,782 |   |                  |  
|Comprehensive Income                                                                               |  | $                  | 4,360 |   |                  | $



See accompanying notes to consolidated financial statements.





4







FIRST KEYSTONE CORPORATION AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CASH FLOWS

FOR THE SIX MONTHS ENDED JUNE 30, 2012 AND 2011

(Unaudited)



|(Amounts in thousands)                                                               |  | 2012 |         |   | 2011 |  
|------------------------------------------------------------------------------------ |  | ---- | ------- | - | ---- | -
|OPERATING ACTIVITIES                                                                 |  |      |         |   |      |  
|Net income                                                                           |  | $    | 5,234   |   |      | $
|Adjustments to reconcile net income to net cash provided by operating activities:    |  |      |         |   |      |  
|Provision for loan losses                                                            |  |      | 800     |   |      |  
|Depreciation and amortization                                                        |  |      | 562     |   |      |  
|Premium amortization on investment securities                                        |  |      | 649     |   |      |  
|Discount accretion on investment securities                                          |  |      | (465    | ) |      |  
|Core deposit discount amortization net of accretion                                  |  |      | 141     |   |      |  
|Deferred income (benefit) tax provision                                              |  |      | (171    | ) |      |  
|(Gain) loss on sale of mortgage loans originated for resale                          |  |      | (406    | ) |      |  
|Proceeds from sale of mortgage loans originated for resale                           |  |      | 14,285  |   |      |  
|Originations of mortgage loans originated for resale                                 |  |      | (14,802 | ) |      |  
|(Gain) loss on sales of investment securities                                        |  |      | (1,007  | ) |      |  
|Loss (gain) on sale of foreclosed assets held for resale                             |  |      | 52      |   |      |  
|Decrease (increase) in accrued interest receivable                                   |  |      | 271     |   |      |  
|(Increase) decrease in cash surrender value of bank owned life insurance             |  |      | (367    | ) |      |  
|Decrease (increase) in other assets – net                                            |  |      | 54      |   |      |  
|Decrease (increase) in prepaid FDIC insurance                                        |  |      | 218     |   |      |  
|(Decrease) increase in accrued interest and other expenses                           |  |      | (334    | ) |      |  
|(Decrease) increase in other liabilities                                             |  |      | (194    | ) |      |  
|NET CASH PROVIDED BY OPERATING ACTIVITIES                                            |  | $    | 4,520   |   |      | $
|                                                                                     |  |      |         |   |      |  
|INVESTING ACTIVITIES                                                                 |  |      |         |   |      |  
|Proceeds from sales of investment securities available-for-sale                      |  | $    | 26,908  |   |      | $
|Proceeds from maturities and redemptions of investment securities available-for-sale |  |      | 14,847  |   |      |  
|Purchases of investment securities available-for-sale                                |  |      | (16,078 | ) |      |  
|Proceeds from maturities and redemption of investment securities held-to-maturity    |  |      | 9       |   |      |  
|Proceeds from the redemption of restricted securities                                |  |      | 503     |   |      |  
|Purchases of restricted securities                                                   |  |      | (206    | ) |      |  
|Net (increase) decrease in loans                                                     |  |      | (4,187  | ) |      |  
|Purchases of premises and equipment                                                  |  |      | (3,865  | ) |      |  
|Proceeds from sale of foreclosed assets held for resale                              |  |      | 247     |   |      |  
|NET CASH PROVIDED BY (USED IN) INVESTING ACTIVITIES                                  |  | $    | 18,178  |   |      | $
|                                                                                     |  |      |         |   |      |  
|FINANCING ACTIVITIES                                                                 |  |      |         |   |      |  
|Net (decrease) increase in deposits                                                  |  | $    | (13,731 | ) |      | $
|Net increase (decrease) in short-term borrowings                                     |  |      | 8,776   |   |      |  
|Proceeds from long-term borrowings                                                   |  |      | 5,000   |   |      |  
|Repayment of long-term borrowings                                                    |  |      | (18,782 | ) |      |  
|Proceeds from issuance of treasury stock                                             |  |      | 12      |   |      |  
|Cash dividends paid                                                                  |  |      | (2,723  | ) |      |  
|NET CASH (USED IN) PROVIDED BY FINANCING ACTIVITIES                                  |  | $    | (21,448 | ) |      | $
|                                                                                     |  |      |         |   |      |  
|INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS                                     |  | $    | 1,250   |   |      | $
|CASH AND CASH EQUIVALENTS, BEGINNING                                                 |  |      | 10,179  |   |      |  
|CASH AND CASH EQUIVALENTS, ENDING                                                    |  | $    | 11,429  |   |      | $
|                                                                                     |  |      |         |   |      |  
|SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION                                     |  |      |         |   |      |  
|Cash paid during period for:                                                         |  |      |         |   |      |  
|Cash paid during period for interest                                                 |  | $    | 3,826   |   |      | $
|Cash paid for income taxes                                                           |  |      | 1,264   |   |      |  



See accompanying notes to consolidated financial statements.





5







FIRST KEYSTONE CORPORATION AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

June 30, 2012

(Unaudited)



NOTE 1 — SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES



The accounting policies of First Keystone
Corporation and Subsidiary (the “Corporation”) are in accordance with accounting principles generally accepted in the
United States of America and conform to common practices within the banking industry. The more significant accounting policies
follow:



Principles of Consolidation



The consolidated financial statements include
the accounts of First Keystone Corporation and its wholly-owned subsidiary, First Keystone Community Bank (the “Bank”).
All significant inter-company balances and transactions have been eliminated in consolidation.



Nature of Operations



The Corporation, headquartered in Berwick,
Pennsylvania, provides a full range of banking, trust and related services through its wholly-owned Bank subsidiary and is subject
to competition from other financial institutions in connection with these services. The Bank serves a customer base which includes
individuals, businesses, government, and public and institutional customers primarily located in the Northeast Region of Pennsylvania.
The Bank has 16 full service offices and 18 Automated Teller Machines (“ATM”) located in Columbia, Luzerne, Montour
and Monroe counties. The Corporation and its subsidiary must also adhere to certain federal and state banking laws and regulations
and are subject to periodic examinations made by various federal agencies.



Segment Reporting



The Corporation’s subsidiary acts
as an independent community financial services provider, and offers traditional banking and related financial services to individual,
business, government, and public and institutional customers. Through its branch and ATM network, the Bank offers a full array
of commercial and retail financial services, including the taking of time, savings and demand deposits; the making of commercial,
consumer and mortgage loans; and the providing of other financial services. The Bank also performs personal, corporate, pension
and fiduciary services through its Trust Department.



Management does not separately allocate
expenses, including the cost of funding loan demand, between the commercial, retail, trust and mortgage banking operations of the
Corporation. Currently, management measures the performance and allocates the resources of the Corporation as a single segment.



Use of Estimates



The preparation of these consolidated financial
statements in conformity with accounting principles generally accepted in the United States of America, requires management to
make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and
liabilities at the date of these consolidated financial statements and the reported amounts of income and expenses during the reporting
periods. Actual results could significantly differ from those estimates.



Material estimates that are particularly
susceptible to significant changes include the assessment for impairment of certain investment securities, the allowance for loan
losses, deferred tax assets and liabilities, impairment of goodwill and other intangible assets and foreclosed assets held for
resale. Assumptions and factors used in the estimates are evaluated on an annual basis or whenever events or changes in circumstance
indicate that the previous assumptions and factors have changed. The result of the analysis could result in adjustments to the
estimates.





6







Investment Securities



The Corporation classifies its investment
securities as either “Held-to-Maturity” or “Available-for-Sale” at the time of purchase. Investment securities
are accounted for on a trade date basis. Debt securities are classified as Held-to-Maturity when the Corporation has the ability
and positive intent to hold the securities to maturity. Investment securities classified as Held-to-Maturity are carried at cost
adjusted for amortization of premium and accretion of discount to maturity.



Debt securities not classified as Held-to-Maturity
and equity securities are included in the Available-for-Sale category and are carried at fair value. The amount of any unrealized
gain or loss, net of the effect of deferred income taxes, is reported as accumulated other comprehensive income (loss) in the Consolidated
Statements of Changes in Stockholders’ Equity and in the Consolidated Statements of Comprehensive Income. Management’s
decision to sell Available-for-Sale securities is based on changes in economic conditions controlling the sources and applications
of funds, terms, availability of and yield of alternative investments, interest rate risk and the need for liquidity.



The cost of debt securities classified as
Held-to-Maturity or Available-for-Sale is adjusted for amortization of premiums and accretion of discounts to expected maturity.
Such amortization and accretion, as well as interest and dividends, are included in interest and dividend income from investment
securities. Realized gains and losses are included in net investment securities gains and losses. The cost of investment securities
sold, redeemed or matured is based on the specific identification method.



Restricted Securities



Restricted equity securities consist of
stock in Federal Home Loan Bank of Pittsburgh (“FHLB-Pittsburgh”) and Atlantic Central Bankers Bank (“ACBB”).
These securities do not have a readily determinable fair value because their ownership is restricted and they can be sold back
only to the FHLB-Pittsburgh, ACBB or to another member institution. Therefore, these securities are classified as restricted equity
investment securities, carried at cost, and evaluated for impairment. At June 30, 2012, the Corporation held $4,857,000 in stock
of FHLB-Pittsburgh and $35,000 in stock of ACBB. At December 31, 2011, the Corporation held $5,154,000 in stock of the FHLB-Pittsburgh
and $35,000 in stock of ACBB.



The Corporation evaluated its holding of
restricted stock for impairment and deemed the stock to not be impaired due to the expected recoverability of cost, which equals
the value reflected within the Corporation’s consolidated financial statements. The decision was based on several items ranging
from the estimated true economic losses embedded within FHLB’s mortgage portfolio to the FHLB’s liquidity position
and credit rating. The Corporation utilizes the impairment framework outlined in GAAP to evaluate stock for impairment. The following
factors were evaluated to determine the ultimate recoverability of the cost of the Corporation’s restricted stock holdings;
(i) the significance of the decline in net assets of the FHLB as compared to the capital stock amount for the FHLB and the length
of time this situation has persisted; (ii) commitments by the FHLB to make payments required by law or regulation and the level
of such payments in relation to the operating performance of the FHLB; (iii) the impact of legislative and regulatory changes on
the institutions and, accordingly, on the customer base of the FHLB; (iv) the liquidity position of the FHLB; and (v) whether a
decline is temporary or whether it affects the ultimate recoverability of the FHLB stock based on (a) the materiality of the carrying
amount to the member institution and (b) whether an assessment of the institution’s operational needs for the foreseeable
future allow management to dispose of the stock. Based on the analysis of these factors, the Corporation determined that its holdings
of restricted stock were not impaired at June 30, 2012 and December 31, 2011.



Loans



Loans are stated at their outstanding unpaid
principal balances, net of deferred fees or costs, unearned income and the allowance for loan losses. Interest on loans is recognized
as income over the term of each loan, generally, by the accrual method. Loan origination fees and certain direct loan origination
costs have been deferred with the net amount amortized using the straight line method or the interest method over the contractual
life of the related loans as an interest yield adjustment.



Residential mortgage loans held for resale
are carried at the lower of cost or market on an aggregate basis determined by independent pricing from appropriate federal or
state agency investors. These loans are sold without recourse to the Corporation.



Past-Due Loans —Generally, a loan is considered
to be past-due when scheduled loan payments are in arrears 15 days or more. Delinquent notices are generated automatically when
a loan is 15 days past-due. Collection efforts continue on past-due loans that have not been satisfied, when it is believed that
some chance exists for improvement in the status of the loan. Past-due loans are continually evaluated with the determination for
charge-off being made when no reasonable chance remains that the status of the loan can be improved.





7







Non-Accrual Loans —Generally, a loan is classified
as non-accrual and the accrual of interest on such a loan is discontinued when the contractual payment of principal or interest
has become 90 days past due or management has serious doubts about further collectability of principal or interest, even though
the loan currently is performing. A loan may remain on accrual status if it is in the process of collection and is either guaranteed
or well secured. When a loan is placed on non-accrual status, unpaid interest credited to income in the current year is reversed
and unpaid interest accrued in prior years is charged against interest income. Certain non-accrual loans may continue to perform,
that is, payments are still being received. Generally, the payments are applied to principal. These loans remain under constant
scrutiny and if performance continues, interest income may be recorded on a cash basis based on management's judgment as to collectability
of principal.



Impaired Loans — A loan is considered impaired
when, based on current information and events, it is probable that the Corporation will be unable to collect all amounts due according
to the contractual terms of the loan agreement. Under current accounting standards, the allowance for loan losses related to impaired
loans is based on discounted cash flows using the loan’s effective interest rate or the fair value of the collateral for
certain collateral dependent loans. The recognition of interest income on impaired loans is the same as for non-accrual loans discussed
above.



Allowance for Loan Losses — The allowance for loan
losses is established through provisions for loan losses charged against income. Loans deemed to be uncollectible are charged against
the allowance for loan losses and subsequent recoveries, if any, are credited to the allowance.



The allowance for loan losses is maintained
at a level estimated by management to be adequate to absorb potential loan losses. Management’s periodic evaluation of the
adequacy of the allowance for loan losses is based on the Corporation’s past loan loss experience, known and inherent risks
in the portfolio, adverse situations that may affect the borrower’s ability to repay (including the timing of future payments),
the estimated value of any underlying collateral, composition of the loan portfolio, current economic conditions, and other relevant
factors. This evaluation is inherently subjective as it requires material estimates including the amounts and timing of future
cash flows expected to be received on impaired loans that may be susceptible to significant change.



In addition, the Corporation is subject
to periodic examination by its federal and state examiners, and may be required by such regulators to recognize additions to the
allowance for loan losses based on their assessment of credit information available to them at the time of their examinations.



In addition, an allowance is provided for
possible credit losses on off-balance sheet credit exposures. This allowance is estimated by management and if deemed necessary,
the allowance would be classified in other liabilities on the consolidated balance sheets. As of June 30, 2012 and December 31,
2011, an allowance for possible credit losses on off-balance sheet credit exposures was not recorded.



The allowance consists of specific and general
components. The specific component relates to loans that are individually classified as impaired. Select loans are not aggregated
for collective impairment evaluation, as such; all loans are subject to individual impairment evaluation should the facts and circumstances
pertinent to a particular loan suggest that such evaluation is necessary. Factors considered by management in determining impairment
include payment status and the probability of collecting scheduled principal and interest payments when due. Loans that experience
insignificant payment delays and payment shortfalls generally are not classified as impaired. A loan is considered impaired when,
based on current information and events, it is probable that the Corporation will be unable to collect the scheduled payments of
principal or interest when due according to the contractual terms of the loan agreement. Management determines the significance
of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding
the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record,
and the amount of the shortfall in relation to the principal and interest owed. If a loan is impaired, a portion of the allowance
is allocated so that the loan is reported, net, at the present value of estimated future cash flows using the loan’s existing
rate or at the fair value of collateral if repayment is expected solely from collateral. Troubled debt restructurings are separately
identified for impairment disclosures and are measured at the present value of estimated future cash flows using the loan’s
effective rate at inception. If a trouble debt restructuring is considered to be a collateral dependent loan, the loan is reported,
net, at the fair value of the collateral. For troubled debt restructurings that subsequently default, the Corporation determines
the amount of reserve in accordance with the accounting policy for the allowance for loan losses.





8







The general component covers all other loans
not identified as impaired and is based on historical losses adjusted for current factors. The historical loss component of the
allowance is determined by losses recognized by portfolio segment over the preceding two years. In calculating the historical component
of our allowance, we aggregate loans into one of four portfolio segments: Commercial, Commercial Real Estate, Consumer and Residential.
Risk factors impacting loans in each of the portfolio segments include broad deterioration of property values, reduced consumer
and business spending as a result of continued high unemployment and reduced credit availability and lack of confidence in a sustainable
recovery. Actual loss experience is supplemented with other economic factors based on the risks present for each portfolio segment.
These economic factors include consideration of the following: the concentration of special mention, substandard and doubtful loans
as a percentage of total loans, levels of loan concentration within the portfolio segment or division of a portfolio segment, broad
economic conditions, delinquency trends, volume trends and terms, and policy and management changes.



Premises and Equipment



Premises, improvements, and equipment are
stated at cost less accumulated depreciation computed principally utilizing the straight-line method over the estimated useful
lives of the assets. Long-lived assets are reviewed for impairment whenever events or changes in business circumstances indicate
that the carrying value may not be recovered. Maintenance and minor repairs are charged to operations as incurred. The cost and
accumulated depreciation of the premises and equipment retired or sold are eliminated from the property accounts at the time of
retirement or sale, and the resulting gain or loss is reflected in current operations.



Mortgage Servicing Rights



The Corporation originates and sells real
estate loans to investors in the secondary mortgage market. After the sale, the Corporation may retain the right to service these
loans. When originated mortgage loans are sold and servicing is retained, a servicing asset is capitalized based on relative fair
value at the date of sale. Servicing assets are amortized as an offset to other fees in proportion to, and over the period of,
estimated net servicing income. The unamortized cost is included in other assets in the consolidated balance sheets. The servicing
rights are periodically evaluated for impairment based on their relative fair value.



Foreclosed Assets Held for Resale



Real estate properties acquired through,
or in lieu of, loan foreclosure are held for sale and are initially recorded at fair value on the date of foreclosure establishing
a new cost basis. After foreclosure, valuations are periodically performed by management and if fair value declines subsequent
to foreclosure, a valuation allowance is recorded through expense. The real estate is carried at the lower of carrying amount or
fair value less cost to sell and is included in other assets on the consolidated balance sheets. Revenues derived from and costs
to maintain the assets and subsequent gains and losses on sales are included in non-interest income and expense on the consolidated
statements of income. The total of foreclosed real estate properties amounted to $1,086,000 at June 30, 2012 and $780,000 at December
31, 2011.



Bank Owned Life Insurance



The Corporation invests in Bank Owned Life
Insurance (“BOLI”) with split dollar life provisions. Purchase of BOLI provides life insurance coverage on certain
employees with the Corporation being owner and beneficiary of the policies.



Investments in Real Estate Ventures



The Bank is a limited partner in real estate
ventures that own and operate affordable residential low-income housing apartment buildings for elderly and mentally challenged
adult residents. The investments are accounted for under the effective yield method. Under the effective yield method, the Bank
recognizes tax credits as they are allocated and amortizes the initial cost of the investment to provide a constant effective yield
over the period that the tax credits are allocated to the Bank. Under this method, the tax credits allocated, net of any amortization
of the investment in the limited partnerships, are recognized in the consolidated statements of income as a component of income
tax expense. The amount of tax credits allocated to the Bank were $277,000 in 2012 and $160,000 in 2011, and the amortization of
the investments in the limited partnerships were $102,000 for the six months ended June 30, 2012 and $58,000 for the six months
ended June 30, 2011.





9







Income Taxes



The provision for income taxes is based
on the results of operations, adjusted primarily for tax-exempt income. Certain items of income and expense are reported in different
periods for financial reporting and tax return purposes. Deferred tax assets and liabilities are determined based on the differences
between the consolidated financial statement and income tax bases of assets and liabilities measured by using the enacted tax rates
and laws expected to be in effect when the timing differences are expected to reverse. Deferred tax expense or benefit is based
on the difference between deferred tax asset or liability from period to period.



In assessing the ultimate realization of
deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets
will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income
during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred
tax liabilities, the projected future taxable income and tax planning strategies in making this assessment. A valuation allowance,
if needed, reduces deferred tax assets to the amount expected to be realized.



A tax position is recognized as a benefit
only if it is “more likely than not” that the tax position would be sustained in a tax examination, with a tax examination
being presumed to occur. The amount recognized is the largest amount of tax benefit that is greater than 50% likely of being realized
on examination. For tax positions not meeting the “more likely than not” test, no tax benefit is recorded.



The Corporation and the Bank are subject
to U.S. federal income tax and Commonwealth of Pennsylvania tax. The Corporation is no longer subject to examination by Federal
or State taxing authorities for the years before 2008. At June 30, 2012 and December 31, 2011, the Corporation did not have any
unrecognized tax benefits. The Corporation does not expect the amount of any unrecognized tax benefits to significantly increase
in the next twelve months. The Corporation recognizes interest related to income tax matters as interest expense and penalties
related to income tax matters as non-interest expense. At June 30, 2012 and December 31, 2011, the Corporation does not have any
amounts accrued for interest and/or penalties.



Goodwill, Other Intangible Assets, and Premium Discount



Goodwill resulted from the acquisition of
the Pocono Community Bank in November 2007 and of certain fixed and operating assets acquired and deposit liabilities assumed of
the branch of another financial institution in Danville, Pennsylvania, in January 2004. Such goodwill represents the excess cost
of the acquired assets relative to the assets fair value at the dates of acquisition. During the first quarter of 2008, $152,000
of liabilities related to the Pocono acquisition were recorded as a purchase accounting adjustment resulting in an increase in
the excess purchase price. The amount was comprised of the finalization of severance agreements and contract terminations related
to the acquisition. In accordance with current accounting standards, goodwill is not amortized. Management performs an annual evaluation
for impairment. Any impairment of goodwill results in a charge to income. The Corporation periodically assesses whether events
or changes in circumstances indicate that the carrying amounts of goodwill and other intangible assets may be impaired. Goodwill
is tested for impairment at the reporting unit level and an impairment loss is recorded to the extent that the carrying amount
of goodwill exceeds its implied fair value. The Corporation has tested the goodwill included in its consolidated balance sheet
at December 31, 2011, and has determined there was no impairment as of that date or as of June 30, 2012. No assurance can be given
that future impairment tests will not result in a charge to earnings.



Intangible assets are comprised of core
deposit intangibles and premium discount (negative premium) on certificates of deposit acquired. The core deposit intangible is
being amortized over the average life of the deposits acquired as determined by an independent third party. Premium discount (negative
premium) on acquired certificates of deposit resulted from the valuation of certificate of deposit accounts by an independent third
party. The book value of certificates of deposit acquired was greater than their fair value at the date of acquisition which resulted
in a negative premium due to higher cost of the certificates of deposit compared to the cost of similar term financing. The Corporation
has tested the core deposit intangible included in its consolidated balance sheet at December 31, 2011 and has determined there
was no impairment as of that date or as of June 30, 2012. No assurance can be given that future impairment tests will not result
in a charge to earnings.





10







Stock Based Compensation



The Corporation adopted a stock option incentive
plan in 1998. Compensation cost is recognized for stock options to employees based on the fair value of these awards at the date
of grant. A Black-Scholes Option Pricing Model is utilized to estimate the fair value of stock options. Compensation expense is
recognized over the requisite service period. The Plan expired in 2008, and therefore, no stock options are available for issuance.
After adjustments for the effects of stock dividends, options exercised and options forfeited, there remains 19,250 exercisable
options issued and outstanding as of June 30, 2012.



Per Share Data



FASB ASC 260-10, Earnings Per Share,
requires dual presentation of basic and fully diluted earnings per share. Basic earnings per share is calculated by dividing net
income by the weighted average number of shares of common stock outstanding at the end of each period. Diluted earnings per share
is calculated by increasing the denominator for the assumed conversion of all potentially dilutive securities. The Corporation’s
dilutive securities are limited to stock options. The most recent options issued were in December 2007.



Cash Flow Information



For purposes of reporting consolidated cash
flows, cash and cash equivalents include cash on hand and due from banks, interest-bearing deposits in other banks, and federal
funds sold. The Corporation considers cash classified as interest-bearing deposits with other banks as a cash equivalent since
they are represented by cash accounts essentially on a demand basis.



Treasury Stock



The purchase of the Corporation’s
common stock is recorded at cost. At the date of subsequent reissue, the treasury stock account is reduced by the cost of such
stock on a first-in-first-out basis.



Trust Assets and Income



Property held by the Corporation in a fiduciary
or agency capacity for its customers is not included in the accompanying consolidated financial statements since such items are
not assets of the Corporation. Trust Department income is generally recognized on a cash basis and is not materially different
than if it were reported on an accrual basis.



Accumulated Other Comprehensive Income (Loss)



The Corporation is required to present accumulated
other comprehensive income (loss) in a full set of general-purpose financial statements for all periods presented. Accumulated
other comprehensive income (loss) is comprised of net unrealized holding gains (losses) on the available-for-sale investment securities
portfolio. The Corporation has elected to report these effects on the Consolidated Statements of Comprehensive Income.



Accounting Policies Recently Adopted and Pending Accounting
Pronouncements



In May 2011, the FASB issued ASU 2011-04,
Fair Value Measurement: Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs.
The primary purpose of the ASU is to improve the comparability between U.S. GAAP fair value accounting and reporting requirements
and International Financial Reporting Standards (“IFRS”) fair value and reporting requirements. The ASU also requires
additional disclosures about transfers between level 1 and 2 of the fair value hierarchy, quantitative information for level 3
inputs, and the level of the fair value measurement hierarchy for items that are not measured at fair value in the statement of
financial position but for which the fair value is required to be disclosed. The ASU was effective for the interim and annual periods
beginning after December 15, 2011. The adoption of the standard did not have a material impact on the Corporation’s consolidated
financial statements. See Note 8 for further information.





11







In June 2011, the FASB issued ASU 2011-05,
Comprehensive Income: Presentation of Comprehensive Income. The ASU requires presentation of the components of other comprehensive
income (“OCI”) in either a continuous statement of comprehensive income or two separate but consecutive statements.
The update does not change the items presented in OCI and does not affect the calculation or reporting of earnings per share (“EPS”).
In December 2011, the FASB issued ASU 2011-12, Comprehensive Income: Deferral of the Effective Date for Amendments to the Presentation
of Reclassification of Items out of Accumulated Other Comprehensive Income in Accounting Standards update No. 2011-05, which
deferred the effective date for the amendments to the reclassification of items out of accumulated other comprehensive income (“AOCI”).
The guidance was effective for fiscal years and interim periods within those years beginning after December 15, 2011, and must
be applied retrospectively for all periods presented. Total other comprehensive income and the components of other comprehensive
income are presented in the Consolidated Statements of Comprehensive Income.



In September 2011, the FASB issued ASU 2011-08,
Intangibles - Goodwill and Other: Testing Goodwill for Impairment, to simplify the current two-step goodwill impairment
test in FASB ASC Topic 350-20, Intangibles – Goodwill and Other: Goodwill. The update permits entities to first perform
a qualitative assessment to determine whether or not it is more likely than not (a likelihood of more than 50 percent) that the
fair value of a reporting unit is less than its carrying amount. If the entity determines that it is more likely than not that
the fair value of a reporting unit is less than its carrying amount, it would then perform the first step of the goodwill impairment
test; otherwise, no further impairment test would be required. The guidance was effective for annual and interim goodwill impairment
tests performed for fiscal years beginning after December 15, 2011. The Corporation adopted the standard as of January 1, 2012
and will apply the new guidance to future goodwill impairment testing. The adoption of the standard did not have a material impact
on the Corporation’s consolidated financial statements or its goodwill impairment evaluation.



In
December 2011, the FASB issued ASU 2011-11, Balance Sheet: Disclosures about Offsetting Assets and Liabilities, to increase
the disclosure requirements surrounding derivative instruments that are offset within the balance sheet pursuant to the provisions
of current U.S. GAAP. The objective of the update is to provide greater comparability between issuers reporting under U.S. GAAP
versus IFRS and provide users the ability to evaluate the effect of netting arrangements on a company’s financial statements.
The ASU is effective for annual reporting periods beginning on or after January 1, 2013, and interim periods within those annual
periods with retrospective disclosure for all comparative periods presented. The Corporation is evaluating the impact of the ASU;
however, the Corporation does not anticipate this update will have a material impact on its consolidated financial statements.



Advertising Costs



It is the Corporation’s policy to
expense advertising costs in the period in which they are incurred. Advertising expense for the six months ended June 30, 2012
and 2011, was approximately $140,000 and $111,000, respectively.



Reclassifications



The Corporation reclassified certain
immaterial amounts in the Consolidated Statements of Income. Such reclassifications have no effect on the Corporation’s consolidated
financial condition or net income.





12







NOTE 2 — INVESTMENT SECURITIES



The amortized cost, related estimated fair
value, and unrealized gains and losses for investment securities classified as “Available-For-Sale” or “Held-to-Maturity”
were as follows at June 30, 2012 and December 31, 2011:



|                                                          |  | Available-for-Sale Securities |        
|--------------------------------------------------------- |  | ----------------------------- | -------
|(Amounts in thousands)                                    |  |                               |        
|                                                          |  | Amortized                     |        
|June 30, 2012:                                            |  | Cost                          |        
|Obligations of U.S. Government Corporations and Agencies: |  |                               |        
|Mortgage-backed                                           |  | $                             | 48,777 
|Other                                                     |  |                               | 15,307 
|Obligations of state and political subdivisions           |  |                               | 172,100
|Corporate securities                                      |  |                               | 54,448 
|Marketable equity securities                              |  |                               | 1,574  
|Restricted equity securities                              |  |                               | 4,892  
|Total                                                     |  | $                             | 297,098



|                                                          |  | Held-to-Maturity Securities |      
|--------------------------------------------------------- |  | --------------------------- | -----
|(Amounts in thousands)                                    |  |                             |      
|                                                          |  | Amortized                   |      
|June 30, 2012:                                            |  | Cost                        |      
|Obligations of U.S. Government Corporations and Agencies: |  |                             |      
|Mortgage-backed                                           |  | $                           | 114  
|Other                                                     |  |                             | 2,010
|Obligations of state and political subdivisions           |  |                             | 467  
|Total                                                     |  | $                           | 2,591



|                                                          |  | Available-for-Sale Securities |        
|--------------------------------------------------------- |  | ----------------------------- | -------
|(Amounts in thousands)                                    |  |                               |        
|                                                          |  | Amortized                     |        
|December 31, 2011:                                        |  | Cost                          |        
|Obligations of U.S. Government Corporations and Agencies: |  |                               |        
|Mortgage-backed                                           |  | $                             | 64,892 
|Other                                                     |  |                               | 13,187 
|Obligations of state and political subdivisions           |  |                               | 177,139
|Corporate securities                                      |  |                               | 60,263 
|Marketable equity securities                              |  |                               | 1,574  
|Restricted equity securities                              |  |                               | 5,189  
|Total                                                     |  | $                             | 322,244



|                                                          |  | Held-to-Maturity Securities |      
|--------------------------------------------------------- |  | --------------------------- | -----
|(Amounts in thousands)                                    |  |                             |      
|                                                          |  | Amortized                   |      
|December 31, 2011:                                        |  | Cost                        |      
|Obligations of U.S. Government Corporations and Agencies: |  |                             |      
|Mortgage-backed                                           |  | $                           | 124  
|Other                                                     |  |                             | 2,014
|Obligations of state and political subdivisions           |  |                             | 467  
|Total                                                     |  | $                           | 2,605



Securities Available-for-Sale with an aggregate
fair value of $181,820,000 at June 30, 2012 and $182,478,000 at December 31, 2011; and securities Held-to-Maturity with an aggregate
book value of $1,125,000 at June 30, 2012 and $2,138,000 at December 31, 2011, were pledged to secure public funds, trust funds,
securities sold under agreements to repurchase, FHLB advances and other balances of $81,172,000 at June 30, 2012 and $106,647,000
at December 31, 2011.





13







The amortized cost, estimated fair value
and weighted average yield of debt securities, by contractual maturity, are shown below at June 30, 2012 and December 31, 2011.
Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations
with or without call or prepayment penalties.



(Amounts in thousands)



|                       |  | June 30, 2012   |       
|---------------------- |  | --------------- | ------
|                       |  | U.S. Government |       
|                       |  | Corporations &  |       
|                       |  | Agencies        |       
|                       |  | Obligations1    |       
|Available-For-Sale:    |  |                 |       
|Within 1 Year:         |  |                 |       
|Amortized cost         |  | $               | 1,002 
|Estimated fair value   |  |                 | 1,007 
|Weighted average yield |  |                 | 1.35  
|1 - 5 Years:           |  |                 |       
|Amortized cost         |  |                 | 12,147
|Estimated fair value   |  |                 | 12,260
|Weighted average yield |  |                 | 1.03  
|5 - 10 Years:          |  |                 |       
|Amortized cost         |  |                 | 4,350 
|Estimated fair value   |  |                 | 4,676 
|Weighted average yield |  |                 | 4.60  
|After 10               |  |                 |       
|Amortized cost         |  |                 | 46,585
|Estimated fair value   |  |                 | 49,185
|Weighted average yield |  |                 | 3.64  
|Total:                 |  |                 |       
|Amortized cost         |  | $               | 64,084
|Estimated fair value   |  |                 | 67,128
|Weighted average yield |  |                 | 3.16  

_______________________

1Mortgage-backed securities are allocated for maturity
reporting at their original maturity date.

2Average yields on tax-exempt obligations of state
and political subdivisions have been computed on a tax-equivalent basis using a 34% tax rate.

3Marketable equity securities and restricted equity
securities are not considered to have defined maturities and are included in the after ten year category.





14







(Amounts in thousands)



|                       |  | June 30, 2012   |      
|---------------------- |  | --------------- | -----
|                       |  | U.S. Government |      
|                       |  | Corporations &  |      
|                       |  | Agencies        |      
|                       |  | Obligations1    |      
|Held-To-Maturity:      |  |                 |      
|Within 1 Year:         |  |                 |      
|Amortized cost         |  | $               | 0    
|Estimated fair value   |  |                 | 0    
|Weighted average yield |  |                 | 0    
|1 - 5 Years:           |  |                 |      
|Amortized cost         |  |                 | 2,010
|Estimated fair value   |  |                 | 2,047
|Weighted average yield |  |                 | 1.37 
|5 - 10 Years:          |  |                 |      
|Amortized cost         |  |                 | 114  
|Estimated fair value   |  |                 | 119  
|Weighted average yield |  |                 | 2.56 
|After 10 Years:        |  |                 |      
|Amortized cost         |  |                 | 467  
|Estimated fair value   |  |                 | 480  
|Weighted average yield |  |                 | 7.14 
|Total:                 |  |                 |      
|Amortized cost         |  | $               | 2,591
|Estimated fair value   |  |                 | 2,646
|Weighted average yield |  |                 | 2.47 

_______________________

1Mortgage-backed securities are allocated for maturity
reporting at their original maturity date.

2Average yields on tax-exempt obligations of state
and political subdivisions have been computed on a tax-equivalent basis using a 34% tax rate.

3Marketable equity securities and restricted equity
securities are not considered to have defined maturities and are included in the after ten year category.





15







(Amounts in thousands)



|                       |  | December 31, 2011 |       
|---------------------- |  | ----------------- | ------
|                       |  | U.S. Government   |       
|                       |  | Agency &          |       
|                       |  | Corporation       |       
|                       |  | Obligations1      |       
|Available-For-Sale:    |  |                   |       
|Within 1 Year:         |  |                   |       
|Amortized cost         |  | $                 | 2,016 
|Estimated fair value   |  |                   | 2,030 
|Weighted average yield |  |                   | 1.20  
|1 - 5 Years:           |  |                   |       
|Amortized cost         |  |                   | 11,175
|Estimated fair value   |  |                   | 11,250
|Weighted average yield |  |                   | 1.17  
|5 - 10 Years:          |  |                   |       
|Amortized cost         |  |                   | 6,905 
|Estimated fair value   |  |                   | 7,285 
|Weighted average yield |  |                   | 4.04  
|After 10 Years:        |  |                   |       
|Amortized cost         |  |                   | 57,983
|Estimated fair value   |  |                   | 60,491
|Weighted average yield |  |                   | 3.66  
|Total:                 |  |                   |       
|Amortized cost         |  | $                 | 78,079
|Estimated fair value   |  |                   | 81,056
|Weighted average yield |  |                   | 3.27  

_______________________

1Mortgage-backed securities are allocated for maturity
reporting at their original maturity date.

2Average yields on tax-exempt obligations of state
and political subdivisions have been computed on a tax-equivalent basis using a 34% tax rate.

3Marketable equity securities and restricted equity
securities are not considered to have defined maturities and are included in the after ten year category.





16







(Amounts in thousands)



|                       |  | December 31, 2011 |      
|---------------------- |  | ----------------- | -----
|                       |  | U.S. Government   |      
|                       |  | Corporations &    |      
|                       |  | Agencies          |      
|                       |  | Obligations1      |      
|Held-to-Maturity:      |  |                   |      
|Within 1 Year:         |  |                   |      
|Amortized cost         |  | $                 | 0    
|Estimated fair value   |  |                   | 0    
|Weighted average yield |  |                   | 0    
|1 - 5 Years:           |  |                   |      
|Amortized cost         |  |                   | 2,014
|Estimated fair value   |  |                   | 2,060
|Weighted average yield |  |                   | 1.41 
|5 - 10 Years:          |  |                   |      
|Amortized cost         |  |                   | 124  
|Estimated fair value   |  |                   | 128  
|Weighted average yield |  |                   | 2.56 
|After 10 Years:        |  |                   |      
|Amortized cost         |  |                   | 0    
|Estimated fair value   |  |                   | 0    
|Weighted average yield |  |                   | 0    
|Total:                 |  |                   |      
|Amortized cost         |  | $                 | 2,138
|Estimated fair value   |  |                   | 2,188
|Weighted average yield |  |                   | 1.48 

_______________________

1Mortgage-backed securities are allocated for maturity
reporting at their original maturity date.

2Average yields on tax-exempt obligations of state
and political subdivisions have been computed on a tax-equivalent basis using a 34% tax rate.

3Marketable equity securities and restricted equity
securities are not considered to have defined maturities and are included in the after ten year category.



There were no aggregate investments with
a single issuer (excluding the U.S. Government and its agencies) which exceeded ten percent of consolidated shareholders’
equity at June 30, 2012. The quality rating of the obligations of state and political subdivisions are generally investment grade,
as rated by Moody’s, Standard and Poor’s or Fitch. The typical exceptions are local issues which are not rated, but
are secured by the full faith and credit obligations of the communities that issued these securities. The state and political subdivision
investments are actively traded in a liquid market.



Proceeds from sale of investments in Available-for-Sale
debt and equity securities during the second quarter of 2012 and 2011 were $18,197,000 and $0, respectively. Gross gains realized
on these sales were $979,000 and $0, respectively. Gross losses on these sales were $2,000 and $0, respectively. There were no
impairment losses in 2012 and 2011.



There were no proceeds from sale of investments
in Held-to-Maturity debt and equity securities during the second quarter of 2012 and 2011. There were no gains or losses realized
during these periods.



Management evaluates securities for other-than-temporary
impairment (“OTTI”) at least on a quarterly basis, and more frequently when economic or market conditions warrant such
an evaluation. Investment securities classified as available-for-sale or held-to-maturity are generally evaluated for OTTI under
FASB ASC 320, Investments - Debt and Equity Securities. In determining OTTI under the FASB ASC 320 model, management considers
many factors, including (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial
condition and near-term prospects of the issuer, (3) whether the market decline was affected by macroeconomic conditions, and (4)
whether the entity has the intent to sell the debt security or more likely than not will be required to sell the debt security
before its anticipated recovery. The assessment of whether an other-than-temporary decline exists involves a high degree of subjectivity
and judgment and is based on the information available to management at a point in time.





17







When other-than-temporary impairment occurs,
the amount of the other-than-temporary impairment recognized in earnings depends on whether an entity intends to sell the security
or more likely than not will be required to sell the security before recovery of its amortized cost basis less any current-period
credit loss. If an entity intends to sell or more likely than not will be required to sell the security before recovery of its
amortized cost basis less any current-period credit loss, the other-than-temporary impairment shall be recognized in earnings equal
to the entire difference between the investment’s amortized cost basis and its fair value at the balance sheet date. If an
entity does not intend to sell the security and it is not more likely than not that the entity will be required to sell the security
before recovery of its amortized cost basis less any current-period loss, the other-than-temporary impairment shall be separated
into the amount representing the credit loss and the amount related to all other factors. The amount of the total other-than-temporary
impairment related to the credit loss is determined based on the present value of cash flows expected to be collected and is recognized
in earnings. The amount of the total other-than-temporary impairment related to the other factors shall be recognized in other
comprehensive income, net of applicable taxes. The previous amortized cost basis less the other-than-temporary impairment recognized
in earnings shall become the new amortized cost basis of the investment.



The fair market value of the equity securities
tends to fluctuate with the overall equity markets as well as the trends specific to each institution. The equity securities portfolio
is reviewed in a similar manner as that of the debt securities with greater emphasis placed on the length of time the market value
has been less than the carrying value and the financial sector outlook. The Corporation also reviews dividend payment activities,
levels of non-performing assets and loan loss reserves. The starting point for the equity analysis is the length and severity of
market value decline. The Corporation and its investment advisors monitor the entire portfolio monthly with particular attention
given to securities in a continuous loss position of at least ten percent for over twelve months. Based on the factors described
above, management did not consider any equity securities to be other-than-temporary impaired at June 30, 2012 and December 31,
2011.



In accordance with disclosures required
by FASB ASC 320-10-50, Investments - Debt and Equity Securities, the summary below shows the gross unrealized losses and
fair value of the Corporation’s investments, aggregated by investment category, that individual securities have been in a
continuous unrealized loss position for less than 12 months or 12 months or more as of June 30, 2012 and December 31, 2011:



|June 30, 2012                    |  |                     |       |  |                   |   |     |       |  |   |            |  |  |       |       |  |            |  
|-------------------------------- |  | ------------------- | ----- |  | ----------------- | - | --- | ----- |  | - | ---------- |  |  | ----- | ----- |  | ---------- | -
|                                 |  | Less Than 12 Months |       |  | 12 Months or More |   |     | Total | 
|                                 |  | Fair                |       |  | Unrealized        |   |     | Fair  |  |   | Unrealized |  |  | Fair  |       |  | Unrealized |  
|(Amounts in thousands)           |  | Value               |       |  | Loss              |   |     | Value |  |   | Loss       |  |  | Value |       |  | Loss       |  
|                                 |  |                     |       |  |                   |   |     |       |  |   |            |  |  |       |       |  |            |  
|Direct obligations of the        |  |                     |       |  |                   |   |     |       |  |   |            |  |  |       |       |  |            |  
|U.S. Government                  |  | $                   | 0     |  |                   | $ | 0   |       |  | $ | 0          |  |  | $     | 0     |  |            | $
|Federal agency backed securities |  |                     | 0     |  |                   |   | 0   |       |  |   | 0          |  |  |       | 0     |  |            |  
|Municipal bonds                  |  |                     | 459   |  |                   |   | 1   |       |  |   | 6,685      |  |  |       | 988   |  |            |  
|Corporate securities             |  |                     | 4,921 |  |                   |   | 133 |       |  |   | 16,414     |  |  |       | 468   |  |            |  
|Marketable equity securities     |  |                     | 230   |  |                   |   | 25  |       |  |   | 286        |  |  |       | 56    |  |            |  
|                                 |  | $                   | 5,610 |  |                   | $ | 159 |       |  | $ | 23,385     |  |  | $     | 1,512 |  |            | $



|December 31, 2011                |  |                     |        |  |                   |   |       |       |  |   |            |  |  |       |       |  |            |  
|-------------------------------- |  | ------------------- | ------ |  | ----------------- | - | ----- | ----- |  | - | ---------- |  |  | ----- | ----- |  | ---------- | -
|                                 |  | Less Than 12 Months |        |  | 12 Months or More |   |       | Total | 
|                                 |  | Fair                |        |  | Unrealized        |   |       | Fair  |  |   | Unrealized |  |  | Fair  |       |  | Unrealized |  
|(Amounts in thousands)           |  | Value               |        |  | Loss              |   |       | Value |  |   | Loss       |  |  | Value |       |  | Loss       |  
|                                 |  |                     |        |  |                   |   |       |       |  |   |            |  |  |       |       |  |            |  
|Direct obligations of the        |  |                     |        |  |                   |   |       |       |  |   |            |  |  |       |       |  |            |  
|U.S. Government                  |  | $                   | 6,118  |  |                   | $ | 6     |       |  | $ | 0          |  |  | $     | 0     |  |            | $
|Federal agency backed securities |  |                     | 7,806  |  |                   |   | 41    |       |  |   | 0          |  |  |       | 0     |  |            |  
|Municipal bonds                  |  |                     | 2,455  |  |                   |   | 11    |       |  |   | 10,518     |  |  |       | 2,189 |  |            |  
|Corporate securities             |  |                     | 32,162 |  |                   |   | 1,185 |       |  |   | 1,791      |  |  |       | 209   |  |            |  
|Marketable equity securities     |  |                     | 82     |  |                   |   | 20    |       |  |   | 754        |  |  |       | 105   |  |            |  
|                                 |  | $                   | 48,623 |  |                   | $ | 1,263 |       |  | $ | 13,063     |  |  | $     | 2,503 |  |            | $





18







The Corporation invests in various forms
of agency debt including mortgage backed securities and callable debt. The mortgage backed securities are issued by FHLMC (“Federal
Home Loan Mortgage Corporation”) or FNMA (“Federal National Mortgage Association”). The municipal securities
consist of general obligations and revenue bonds. The marketable equity securities consist of stocks in other bank holding companies.
The fair market value of the above securities is influenced by market interest rates, prepayment speeds on mortgage securities,
bid offer spreads in the market place and credit premiums for various types of agency debt. These factors change continuously and
therefore the market value of these securities may be higher or lower than the Corporation’s carrying value at any measurement
date. Management does not believe any of their 34 securities in an unrealized loss position as of June 30, 2012 represents an other-than-temporary
impairment. The Corporation has the ability to hold the remaining securities contained in the above table for a time necessary
to recover the cost.



Securities with an unrealized loss that
are determined to be other-than-temporary are written down to fair value, with the write-down recorded as a realized loss included
in investment securities gains (losses) expense-net on the consolidated statements of income.





NOTE 3 — LOANS



Major classifications of loans at June 30,
2012 and December 31, 2011 consisted of:



(Amounts in thousands)



|                                       |  | June 30, |         |   | December 31, |  
|-------------------------------------- |  | -------- | ------- | - | ------------ | -
|                                       |  | 2012     |         |   | 2011         |  
|Commercial, Financial and Agricultural |  | $        | 24,853  |   |              | $
|Tax-exempt - Real Estate and Other     |  |          | 22,211  |   |              |  
|Real estate mortgages - Held-for-sale  |  |          | 894     |   |              |  
|Real estate mortgages - Consumer       |  |          | 136,295 |   |              |  
|Real estate mortgages - Commercial     |  |          | 228,597 |   |              |  
|Consumer                               |  |          | 6,697   |   |              |  
|Gross loans                            |  |          | 419,547 |   |              |  
|Add (deduct): Unearned discount and    |  |          | (235    | ) |              |  
|Net deferred loan fees and costs       |  |          | 326     |   |              |  
|Total loans, net of unearned income    |  | $        | 419,638 |   |              | $



Activity in the allowance for loan losses
for the six months ended June 30, 2012 and the year ended December 31, 2011:



(Amounts in thousands)

|                                |  | June 30, |       |   | December 31, |  
|------------------------------- |  | -------- | ----- | - | ------------ | -
|                                |  | 2012     |       |   | 2011         |  
|Balance at beginning of period  |  | $        | 5,929 |   |              | $
|Provision charged to operations |  |          | 800   |   |              |  
|Loans charged off               |  |          | (962  | ) |              |  
|Recoveries                      |  |          | 57    |   |              |  
|Balance at end of period        |  | $        | 5,824 |   |              | $





Loan risk grading is a management tool designed
to identify and measure risk in the Bank’s loan portfolio. Its purpose is to provide a uniform framework and common language
to assess and monitor risk, primarily in the Bank’s commercial loan/commercial real estate loan portfolios.



The grading system focuses on a borrower’s
financial strength and performance, experience and depth of management, primary and secondary sources of repayment, the nature
of the business and the outlook for the particular industry. Primary emphasis will be on the financial condition and trends. The
grade also reflects current economic and industry conditions; as well as other variables such as liquidity, cash flow, revenue/earnings
trends, management strengths or weaknesses, quality of financial information, and credit history.





19







Overall, the portfolio risk profile as measured
by loan grade is considered low risk, as $409,149,000 or 97.5% of gross loans are graded Pass; $3,160,000 or 0.8% are graded Special
Mention; $7,238,000 or 1.7% are graded Substandard; and $0 are graded Doubtful.



Commercial & Industrial non-pass grades
decreased to $1,372,000 as of June 30, 2012, as compared to $1,436,000 as of December 31, 2011. Commercial Real Estate non-pass
grades decreased to $8,154,000 as of June 30, 2012, as compared to $10,375,000 as of December 31, 2011. The $2,221,000 decrease
in Commercial Real Estate was the result of $1,172,000 in loans upgraded, $520,000 in loans charged-down, and $218,000 in loans
transferred into foreclosed assets held for resale, with the balance attributed to borrower repayments. The Residential Real Estate
and Consumer Loans non-pass grades decreased to $872,000 as of June 30, 2012 compared to $1,115,000 as of December 31, 2011. The
reduction in Residential Real Estate was due to one large residential property being transferred into foreclosed assets held for
resale.



The Bank utilizes a risk grading matrix
as a tool for managing credit risk in the loan portfolio and assigns an Asset Quality Rating (risk grade) to all retail, commercial
and commercial real estate borrowing relationships. An asset quality rating is assigned using the guidance provided in the Bank’s
loan policy, which was revised in the second quarter of 2012. Primary responsibility for assigning the asset quality rating rests
with the lender. The asset quality rating is validated periodically by both an internal and external loan review process. The rating
will always represent the best assessment of risk available at a given point in time, based upon a review of the borrower’s
financial statements, credit analysis, payment history with our Bank, credit history and lender knowledge of the borrower. Risk
grade characteristics are as follows:



Risk Grade 1 – MINIMAL RISK through Risk Grade 6
– MANAGEMENT ATTENTION (Pass Grade Categories)



Risk is evaluated via examination of several
attributes including but not limited to financial trends and strengths and weaknesses, likelihood of repayment when considering
both cash flow and collateral, sources of repayment, leverage position, management expertise, and repayment history.



At the low-risk end of the rating scale,
a risk grade of 1 - Minimal Risk is the grade reserved for loans with exceptional credit fundamentals and virtually no risk of
default or loss. Loan grades then progress through escalating ratings of 2 through 6 based upon risk. Risk Grade 2 - Modest Risk
are loans with sufficient cash flows; Risk Grade 3 - Average Risk are loans with key balance sheet ratios slightly above the borrower’s
peers; Risk Grade 4 - Acceptable Risk are loans with key balance sheet ratios usually near the borrower’s peers, but one
or more ratios may be higher; and Risk Grade 5 – Marginally Acceptable are loans with strained cash flow, increasing leverage
and/or weakening markets. Risk Grade 6 - Management Attention are loans with weaknesses resulting from declining performance trends
and the borrower’s cash flows may be temporarily strained. Loans in this category are performing according to terms, but
present some type of potential concern.



Risk Grade 7 − SPECIAL MENTION (Non-Pass Category)



Generally, these loans or assets are currently
protected, but are “Potentially Weak”. They constitute an undue and unwarranted credit risk but not to the point of
justifying a classification of substandard.



Assets in this category are currently protected
but have potential weakness which may, if not checked or corrected, weaken the asset or inadequately protect the Bank’s credit
position at some future date. No loss of principal or interest is envisioned, however they constitute an undue credit risk that
may be minor but is unwarranted in light of the circumstances surrounding a specific asset. Risk is increasing beyond that at which
the loan originally would have been granted. Historically, cash flows are inconsistent; financial trends show some deterioration.
Liquidity and leverage are above industry averages. Financial information could be incomplete or inadequate. A Special Mention
asset has potential weaknesses that deserve management’s close attention.



Risk Grade 8 − SUBSTANDARD (Non-Pass Category)



Generally, these assets are inadequately
protected by the current sound worth and paying capacity of the obligor or of the collateral pledged, if any. Assets so classified
must have “well-defined” weaknesses that jeopardize the full liquidation of the debt. There is a distinct possibility
that the Bank will sustain some loss.





20







They are characterized by the distinct possibility
that the Bank will sustain some loss if in the aggregate amount of substandard assets, is not fully covered by the liquidation
of the collateral used as security. Substandard loans are inadequately protected by current sound net worth, paying capacity of
the borrower, or pledged collateral, and have a high probability of payment default, or they have other well-defined weaknesses.
Such assets require more intensive supervision by Bank Management.



Risk Grade 9 − DOUBTFUL (Non-Pass Category)



Generally, loans graded doubtful have all
the weaknesses inherent in a substandard loan with the added factor that the weaknesses are pronounced to a point where the basis
of current information, conditions, and values, collection or liquidation in full is highly improbable. The possibility of loss
is extremely high, but because of certain important and reasonably specific pending factors that may work to strengthen the asset,
its classification is deferred until, for example, a proposed merger, acquisition, liquidation procedures, capital injection, perfection
of liens on additional collateral and/or refinancing plans are completed. Loans are graded doubtful if they contain weaknesses
so serious that collection or liquidation in full is questionable.



The credit quality indicators by loan segment
are summarized below at June 30, 2012 and December 31, 2011:



|                                |  | Commercial & |        |  | Commercial Real Estate |  
|------------------------------- |  | ------------ | ------ |  | ---------------------- | -
|                                |  | Industrial   |        |  | Construction           |  
|                                |  | June 30,     |        |  | December 31,           |  
|                                |  | 2012         |        |  | 2011                   |  
|Grade:                          |  |              |        |  |                        |  
|1-6   Pass                      |  | $            | 43,196 |  |                        | $
|7      Special Mention          |  |              | 680    |  |                        |  
|8      Substandard              |  |              | 692    |  |                        |  
|9      Doubtful                 |  |              | 0      |  |                        |  
|Add (deduct): Unearned discount |  |              | 0      |  |                        |  
|Net deferred loan fees & costs  |  |              | 114    |  |                        |  
|Loans, net of unearned income   |  | $            | 44,682 |  |                        | $



|                                |  | Commercial Real Estate |         |   | Residential Real Estate |  
|------------------------------- |  | ---------------------- | ------- | - | ----------------------- | -
|                                |  | Other                  |         |   | Including Home Equity   |  
|                                |  | June 30,               |         |   | December 31,            |  
|                                |  | 2012                   |         |   | 2011                    |  
|Grade:                          |  |                        |         |   |                         |  
|1-6   Pass                      |  | $                      | 217,948 |   |                         | $
|7      Special Mention          |  |                        | 2,340   |   |                         |  
|8      Substandard              |  |                        | 5,814   |   |                         |  
|9      Doubtful                 |  |                        | 0       |   |                         |  
|Add (deduct): Unearned discount |  |                        | 0       |   |                         |  
|Net deferred loan fees & costs  |  |                        | (7      | ) |                         |  
|Loans, net of unearned income   |  | $                      | 226,095 |   |                         | $



|                                |  | Consumer Loans |      
|------------------------------- |  | -------------- | -----
|                                |  | June 30,       |      
|                                |  | 2012           |      
|Grade:                          |  |                |      
|1-6    Pass                     |  | $              | 6,678
|7       Special Mention         |  |                | 3    
|8       Substandard             |  |                | 16   
|9       Doubtful                |  |                | 0    
|Add (deduct): Unearned discount |  |                | (235 
|Net deferred loan fees & costs  |  |                | 75   
|Loans, net of unearned income   |  | $              | 6,537





21







Commercial C & I and Commercial Real
Estate Other include loans categorized as tax free loans.



The activity in the allowance for loan losses,
by loan segment, is summarized below for the years indicated.



|(Amounts in thousands)                                |  |            |        |   | Commercial  |   |         |          |  |   |             |   |  |             |         |   |       |  
|----------------------------------------------------- |  | ---------- | ------ | - | ----------- | - | ------- | -------- |  | - | ----------- | - |  | ----------- | ------- | - | ----- | -
|                                                      |  | Commercial |        |   | Real Estate |   |         | Consumer |  |   | Residential |   |  | Unallocated |         |   | Total |  
|Six months ended June 30, 2012:                       |  |            |        |   |             |   |         |          |  |   |             |   |  |             |         |   |       |  
|Allowance for Loan Losses:                            |  |            |        |   |             |   |         |          |  |   |             |   |  |             |         |   |       |  
|Beginning balance                                     |  | $          | 489    |   |             | $ | 3,507   |          |  | $ | 137         |   |  | $           | 1,228   |   |       | $
|Charge-offs                                           |  |            | (243   | ) |             |   | (520    | )        |  |   | (28         | ) |  |             | (171    | ) |       |  
|Recoveries                                            |  |            | 15     |   |             |   | 20      |          |  |   | 21          |   |  |             | 1       |   |       |  
|Provision                                             |  |            | 185    |   |             |   | 346     |          |  |   | (19         | ) |  |             | 167     |   |       |  
|Ending Balance                                        |  |            | 446    |   |             |   | 3,353   |          |  |   | 111         |   |  |             | 1,225   |   |       |  
|Ending balance: individually evaluated for impairment |  |            | 21     |   |             |   | 753     |          |  |   | 0           |   |  |             | 147     |   |       |  
|Ending balance: collectively evaluated for impairment |  | $          | 425    |   |             | $ | 2,600   |          |  | $ | 111         |   |  | $           | 1,078   |   |       | $
|                                                      |  |            |        |   |             |   |         |          |  |   |             |   |  |             |         |   |       |  
|Financing Receivables:                                |  |            |        |   |             |   |         |          |  |   |             |   |  |             |         |   |       |  
|Ending Balance                                        |  | $          | 44,682 |   |             | $ | 231,085 |          |  | $ | 6,537       |   |  | $           | 137,334 |   |       | $
|Ending balance: individually evaluated for impairment |  |            | 611    |   |             |   | 3,070   |          |  |   | 0           |   |  |             | 584     |   |       |  
|Ending balance: collectively evaluated for impairment |  | $          | 44,071 |   |             | $ | 228,015 |          |  | $ | 6,537       |   |  | $           | 136,750 |   |       | $



|(Amounts in thousands)                                    |  |            |        |   | Commercial  |   |         |          |  |   |             |   |  |             |         |   |       |  
|--------------------------------------------------------- |  | ---------- | ------ | - | ----------- | - | ------- | -------- |  | - | ----------- | - |  | ----------- | ------- | - | ----- | -
|                                                          |  | Commercial |        |   | Real Estate |   |         | Consumer |  |   | Residential |   |  | Unallocated |         |   | Total |  
|December 31, 2011:                                        |  |            |        |   |             |   |         |          |  |   |             |   |  |             |         |   |       |  
|Allowance for Loan Losses:                                |  |            |        |   |             |   |         |          |  |   |             |   |  |             |         |   |       |  
|Beginning balance                                         |  | $          | 565    |   |             | $ | 2,769   |          |  | $ | 123         |   |  | $           | 1,501   |   |       | $
|Charge-offs                                               |  |            | (485   | ) |             |   | (968    | )        |  |   | (98         | ) |  |             | (218    | ) |       |  
|Recoveries                                                |  |            | 28     |   |             |   | 51      |          |  |   | 16          |   |  |             | 2       |   |       |  
|Provision                                                 |  |            | 381    |   |             |   | 1,655   |          |  |   | 96          |   |  |             | (57     | ) |       |  
|Ending Balance                                            |  |            | 489    |   |             |   | 3,507   |          |  |   | 137         |   |  |             | 1,228   |   |       |  
|Ending balance: individually evaluated for impairment     |  |            | 80     |   |             |   | 756     |          |  |   | 0           |   |  |             | 111     |   |       |  
|Ending balance: collectively evaluated for impairment     |  | $          | 409    |   |             | $ | 2,751   |          |  | $ | 137         |   |  | $           | 1,117   |   |       | $
|                                                          |  |            |        |   |             |   |         |          |  |   |             |   |  |             |         |   |       |  
|Financing Receivables:                                    |  |            |        |   |             |   |         |          |  |   |             |   |  |             |         |   |       |  
|Ending Balance                                            |  | $          | 39,786 |   |             | $ | 238,181 |          |  | $ | 7,177       |   |  | $           | 130,851 |   |       | $
|Ending balance: individually evaluated for impairment     |  |            | 122    |   |             |   | 3,211   |          |  |   | 0           |   |  |             | 855     |   |       |  
|Ending balance: collectively evaluated for
    impairment |  | $          | 39,664 |   |             | $ | 234,970 |          |  | $ | 7,177       |   |  | $           | 129,996 |   |       | $







22







Impaired loans at June 30, 2012 and December
31, 2011 were $4,265,000 and $4,188,000, respectively. The gross interest that would have been recorded if these loans had been
current in accordance with their original terms and the amounts actually recorded in income were as follows:



(Amounts in thousands)

|                                            |  | June 30, |     |   | December 31, |  
|------------------------------------------- |  | -------- | --- | - | ------------ | -
|                                            |  | 2012     |     |   | 2011         |  
|Gross interest due under terms year-to-date |  | $        | 188 |   |              | $
|Amount included in income year-to-date      |  |          | (10 | ) |              |  
|Interest income not recognized year-to-date |  | $        | 178 |   |              | $



The Corporation’s impaired loans
are summarized below for the periods ended June 30, 2012 and December 31, 2011.



|(Amounts in thousands)              |  |            |       |  | Unpaid    |   |       |           |  |   | Average    |  |  | Interest   |      
|----------------------------------- |  | ---------- | ----- |  | --------- | - | ----- | --------- |  | - | ---------- |  |  | ---------- | -----
|                                    |  | Recorded   |       |  | Principal |   |       | Related   |  |   | Recorded   |  |  | Income     |      
|June 30, 2012:                      |  | Investment |       |  | Balance   |   |       | Allowance |  |   | Investment |  |  | Recognized |      
|With no related allowance recorded: |  |            |       |  |           |   |       |           |  |   |            |  |  |            |      
|Commercial                          |  | $          | 37    |  |           | $ | 183   |           |  | $ | 0          |  |  | $          | 186  
|Commercial real estate              |  |            | 1,113 |  |           |   | 1,414 |           |  |   | 0          |  |  |            | 1,442
|Residential                         |  |            | 151   |  |           |   | 171   |           |  |   | 0          |  |  |            | 171  
|                                    |  |            |       |  |           |   |       |           |  |   |            |  |  |            |      
|With an allowance recorded:         |  |            |       |  |           |   |       |           |  |   |            |  |  |            |      
|Commercial                          |  |            | 574   |  |           |   | 918   |           |  |   | 21         |  |  |            | 918  
|Commercial real estate              |  |            | 1,957 |  |           |   | 2,937 |           |  |   | 753        |  |  |            | 2,941
|Residential                         |  |            | 433   |  |           |   | 496   |           |  |   | 147        |  |  |            | 503  
|Total                               |  | $          | 4,265 |  |           | $ | 6,119 |           |  | $ | 921        |  |  | $          | 6,161
|                                    |  |            |       |  |           |   |       |           |  |   |            |  |  |            |      
|Total consists of:                  |  |            |       |  |           |   |       |           |  |   |            |  |  |            |      
|Commercial                          |  | $          | 611   |  |           | $ | 1,101 |           |  | $ | 21         |  |  | $          | 1,104
|Commercial real estate              |  | $          | 3,070 |  |           | $ | 4,351 |           |  | $ | 753        |  |  | $          | 4,383
|Residential                         |  | $          | 584   |  |           | $ | 667   |           |  | $ | 147        |  |  | $          | 674  





|(Amounts in thousands)              |  |            |       |  | Unpaid    |   |       |           |  |   | Average    |  |  | Interest   |      
|----------------------------------- |  | ---------- | ----- |  | --------- | - | ----- | --------- |  | - | ---------- |  |  | ---------- | -----
|                                    |  | Recorded   |       |  | Principal |   |       | Related   |  |   | Recorded   |  |  | Income     |      
|December 31, 2011:                  |  | Investment |       |  | Balance   |   |       | Allowance |  |   | Investment |  |  | Recognized |      
|With no related allowance recorded: |  |            |       |  |           |   |       |           |  |   |            |  |  |            |      
|Commercial                          |  | $          | 43    |  |           | $ | 188   |           |  | $ | 0          |  |  | $          | 239  
|Commercial real estate              |  |            | 1,319 |  |           |   | 1,505 |           |  |   | 0          |  |  |            | 1,554
|Residential                         |  |            | 270   |  |           |   | 280   |           |  |   | 0          |  |  |            | 286  
|                                    |  |            |       |  |           |   |       |           |  |   |            |  |  |            |      
|With an allowance recorded:         |  |            |       |  |           |   |       |           |  |   |            |  |  |            |      
|Commercial                          |  |            | 80    |  |           |   | 80    |           |  |   | 80         |  |  |            | 89   
|Commercial real estate              |  |            | 1,891 |  |           |   | 2,932 |           |  |   | 756        |  |  |            | 2,947
|Residential                         |  |            | 585   |  |           |   | 733   |           |  |   | 111        |  |  |            | 736  
|Total                               |  | $          | 4,188 |  |           | $ | 5,718 |           |  | $ | 947        |  |  | $          | 5,851
|                                    |  |            |       |  |           |   |       |           |  |   |            |  |  |            |      
|Total consists of:                  |  |            |       |  |           |   |       |           |  |   |            |  |  |            |      
|Commercial                          |  | $          | 123   |  |           | $ | 268   |           |  | $ | 80         |  |  | $          | 328  
|Commercial real estate              |  | $          | 3,210 |  |           | $ | 4,437 |           |  | $ | 756        |  |  | $          | 4,501
|Residential                         |  | $          | 855   |  |           | $ | 1,013 |           |  | $ | 111        |  |  | $          | 1,022



The recorded investment represents the loan
balance reflected on the consolidated balance sheets net of any charge-offs. The unpaid balance is equal to the gross amount due
on the loan. The average recorded investment is calculated on the daily loan balance during the period of impairment.





23







Financing receivables on non-accrual status
and foreclosed assets as of June 30, 2012 and December 31, 2011 were as follows:



(Amounts in thousands)

|                                                  |  | June 30, |       |  | December 31, |  
|------------------------------------------------- |  | -------- | ----- |  | ------------ | -
|                                                  |  | 2012     |       |  | 2011         |  
|Commercial – real estate                          |  | $        | 3,070 |  |              | $
|Commercial - other                                |  |          | 611   |  |              |  
|Residential                                       |  |          | 584   |  |              |  
|Consumer                                          |  |          | 0     |  |              |  
|Total non-accruing loans                          |  |          | 4,265 |  |              |  
|Restructured loans                                |  |          | 0     |  |              |  
|Total impaired loans                              |  |          | 4,265 |  |              |  
|Loans past-due 90 days or more and still accruing |  |          | 189   |  |              |  
|Foreclosed assets                                 |  |          | 1,086 |  |              |  
|Total non-performing assets                       |  | $        | 5,540 |  |              | $



At June 30, 2012 and December 31, 2011,
the recorded investment in impaired loans as defined by FASB ASC 310-10-35, Receivables Subsequent Measurements, was $4,265,000
and $4,188,000, and the impaired loans allowances were $921,000 and $947,000, respectively at June 30, 2012 and December 31, 2011.
The average recorded balance in impaired loans during the quarter ended June 30, 2012 and December 31, 2011 was approximately $6,161,000
and $5,851,000, respectively.



The following tables present the aging of
past-due loans by class of loans at June 30, 2012 and December 31, 2011:



|(Amounts in thousands) |  |            |       |  |            |   |       | 90 Days    |  |   |          |  |  | Non-       |       |  |         |   |       | Total       | 
|---------------------- |  | ---------- | ----- |  | ---------- | - | ----- | ---------- |  | - | -------- |  |  | ---------- | ----- |  | ------- | - | ----- | ----------- | 
|                       |  | 30-59 Days |       |  | 60-89 Days |   |       | or Greater |  |   | Total    |  |  | Performing |       |  |         |   |       | Financing   | 
|                       |  | Past Due   |       |  | Past Due   |   |       | Past Due   |  |   | Past Due |  |  | Assets     |       |  | Current |   |       | Receivables | 
|June 30, 2012:         |  |            |       |  |            |   |       |            |  |   |          |  |  |            |       |  |         |   |       |             | 
|Commercial             |  | $          | 50    |  |            | $ | 9     |            |  | $ | 0        |  |  | $          | 59    |  |         | $ | 611   |             | 
|Commercial real estate |  |            | 776   |  |            |   | 801   |            |  |   | 123      |  |  |            | 1,700 |  |         |   | 3,070 |             | 
|Consumer               |  |            | 52    |  |            |   | 5     |            |  |   | 0        |  |  |            | 57    |  |         |   | 0     |             | 
|Residential            |  |            | 996   |  |            |   | 412   |            |  |   | 66       |  |  |            | 1,474 |  |         |   | 584   |             | 
|Total                  |  | $          | 1,874 |  |            | $ | 1,227 |            |  | $ | 189      |  |  | $          | 3,290 |  |         | $ | 4,265 |             | 



|(Amounts in thousands) |  |            |       |  |            |   |       | 90 Days    |  |   |          |  |  | Non-       |       |  |         |   |       | Total       | 
|---------------------- |  | ---------- | ----- |  | ---------- | - | ----- | ---------- |  | - | -------- |  |  | ---------- | ----- |  | ------- | - | ----- | ----------- | 
|                       |  | 30-59 Days |       |  | 60-89 Days |   |       | or Greater |  |   | Total    |  |  | Performing |       |  |         |   |       | Financing   | 
|                       |  | Past Due   |       |  | Past Due   |   |       | Past Due   |  |   | Past Due |  |  | Assets     |       |  | Current |   |       | Receivables | 
|December 31, 2011:     |  |            |       |  |            |   |       |            |  |   |          |  |  |            |       |  |         |   |       |             | 
|Commercial             |  | $          | 166   |  |            | $ | 21    |            |  | $ | 0        |  |  | $          | 187   |  |         | $ | 123   |             | 
|Commercial real estate |  |            | 1,427 |  |            |   | 785   |            |  |   | 0        |  |  |            | 2,212 |  |         |   | 3,210 |             | 
|Consumer               |  |            | 64    |  |            |   | 62    |            |  |   | 0        |  |  |            | 126   |  |         |   | 0     |             | 
|Residential            |  |            | 1,473 |  |            |   | 353   |            |  |   | 0        |  |  |            | 1,826 |  |         |   | 855   |             | 
|Total                  |  | $          | 3,130 |  |            | $ | 1,221 |            |  | $ | 0        |  |  | $          | 4,351 |  |         | $ | 4,188 |             | 



Loans past-due 90 days or more and still
accruing interest were $189,000 and $0 at June 30, 2012 and December 31, 2011, respectively. Loans 90 days or greater past-due
remained on accrual status as these assets were deemed to be in the process of collection, guaranteed, or well secured.



At June 30, 2012, there were no commitments
to lend additional funds with respect to non-accrual and restructured loans.





24







From time to time, the Bank may agree to
modify the contractual terms of a borrower’s loan. In cases where such modifications represent a concession to a borrower
experiencing financial difficulty, the modification is considered a troubled debt restructuring. Loans modified in a troubled debt
restructuring are placed on non-accrual status until the Bank determines the future collection of principal and interest is reasonably
assured, which generally requires that the borrower demonstrate a period of performance according to the restructured terms of
six months. At June 30, 2012, there were no loans classified as troubled debt restructurings.





NOTE 4 — SHORT-TERM BORROWINGS



Federal funds purchased, securities sold
under agreements to repurchase, Federal Discount Window, and Federal Home Loan Bank advances generally represent overnight or less
than 30-day borrowings. U.S. Treasury tax and loan notes for collections made by the Bank are payable on demand.





NOTE 5 — LONG-TERM BORROWINGS



Long-term borrowings are comprised of advances
from the Federal Home Loan Bank (“FHLB”) and a capital lease assumed as a result of the acquisition of Pocono Community
Bank in the amount of $811,000 on November 1, 2007. Under terms of a blanket agreement, collateral for the loans are secured by
certain qualifying assets of the Corporation’s banking subsidiary with FHLB, which consist principally of real estate mortgages
and certain investment securities.



NOTE 6 — COMMITTMENTS AND CONTINGENCIES



In August 2011, the Bank entered into an
agreement with a seller to acquire property consisting of three parcels of vacant land in the amount of $504,000 in Kingston, Pennsylvania.
The property was acquired on February 15, 2012. As of June 30, 2012, the Bank has committed to build a new facility at an approximate
cost of $1,429,000, of which $986,000 has been spent.



In 2011, the Bank began work to expand its
main headquarters in Berwick, Pennsylvania. As of June 30, 2012, the Bank has committed to spend $5.4 million on this facility,
of which $3.1 million has been spent.



In February 2012, the Bank entered into
an agreement with a seller to acquire property consisting of a parcel of land and a building in the amount of $400,000 in Shickshinny,
Pennsylvania. This property was acquired on July 26, 2012.



In the normal course of business, there
are various pending legal actions and proceedings that are not reflected in the consolidated financial statements. Management does
not believe the outcome of these actions and proceedings will have a material effect on the consolidated financial position of
the Corporation.



NOTE 7 — FINANCIAL INSTRUMENTS WITH OFF-BALANCE
SHEET RISK AND CONCENTRATIONS OF CREDIT RISK



The Corporation is a party to financial
instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial
instruments include commitments to extend credit and standby letters of credit. Those instruments involve, to varying degrees,
elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheets. The contract or
notional amounts of those instruments reflect the extent of involvement the Corporation has in particular classes of financial
instruments. The Corporation does not engage in trading activities with respect to any of its financial instruments with off-balance
sheet risk.



The Corporation’s exposure to credit
loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby
letters of credit is represented by the contractual notional amount of those instruments.



The Corporation uses the same credit policies
in making commitments and conditional obligations as it does for on-balance sheet instruments.





25







The Corporation may require collateral or
other security to support financial instruments with off-balance sheet credit risk.



The contract or notional amounts at June
30, 2012 and December 31, 2011, were as follows:



(Amounts in thousands)

|                                                                    |  | June 30, |        |  | December 31, |  
|------------------------------------------------------------------- |  | -------- | ------ |  | ------------ | -
|                                                                    |  | 2012     |        |  | 2011         |  
|Financial instruments whose contract amounts represent credit risk: |  |          |        |  |              |  
|Commitments to extend credit                                        |  | $        | 65,482 |  |              | $
|Financial standby letters of credit                                 |  | $        | 756    |  |              | $
|Performance standby letters of credit                               |  | $        | 3,838  |  |              | $



Commitments to extend credit are agreements
to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have
fixed expiration dates or other termination clauses that may require payment of a fee. Since some of the commitments may expire
without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Corporation evaluates
each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Corporation
upon extension of credit, is based on management’s credit evaluation of the borrower. Collateral held varies but may include
accounts receivable, inventory, property, plant and equipment, owner-occupied income-producing commercial properties, and residential
real estate.



Standby letters of credit are conditional
commitments issued by the Corporation to guarantee payment to a third party when a customer either fails to repay an obligation
or fails to perform some non-financial obligation. The credit risk involved in issuing letters of credit is essentially the same
as that involved in extending loan facilities to customers. The Corporation may hold collateral to support standby letters of credit
for which collateral is deemed necessary.



The Corporation grants commercial, agricultural,
real estate mortgage and consumer loans to customers primarily in the counties of Columbia, Luzerne, Montour and Monroe, Pennsylvania.
It is management’s opinion that the loan portfolio was well balanced and diversified at June 30, 2012, to the extent necessary
to avoid any significant concentration of credit risk. However, its debtor’s ability to honor their contracts may be influenced
by the region’s economy.



NOTE 8 — FAIR VALUES OF FINANCIAL INSTRUMENTS



Fair value is the exchange price that would
be received for an asset or paid to transfer (exit price) in the principal or most advantageous market for the asset and liability
in an orderly transaction between market participants on the measurement date. There are three levels of inputs that may be used
to measure fair value:



| | A. | Level 1: Fair value is based on unadjusted quoted prices in active markets that are accessible to the Corporation for
identical, unrestrictive assets. These generally provide the most reliable evidence and are used to measure fair value whenever
available.
| | -- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | B. | Level 2: Fair value is based on significant other observable inputs, other than Level 1 inputs, that are observable
either directly or indirectly for substantially the full term of the asset through corroboration with observable market data. Level
2 inputs include quoted market prices in active markets for similar assets, quoted market prices that are not active for identical
or similar assets and other observable inputs.
| | -- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | C. | Level 3: Fair value is based on significant unobservable inputs that reflect a reporting entity’s own assumptions
about the assumptions that market participants would use in pricing an asset or liability. Examples of valuation methodologies
that would result in Level 3 classification include option pricing models, discounted cash flows and other similar techniques.
| | -- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



A financial instrument’s level within
the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement. Transfers of
financial instruments between levels within the fair value hierarchy are recognized on the date management determines that the
underlying circumstances or assumptions have changed.





26







Financial Assets Measured at Fair Value on a Recurring Basis



At June 30, 2012 and December 31, 2011,
investments measured at fair value on a recurring basis and the valuation methods used are as follows:



June 30, 2012

|                                                          |  | Level 1 |       |  | Level 2 |   |         | Level 3 |  |   | Total | 
|--------------------------------------------------------- |  | ------- | ----- |  | ------- | - | ------- | ------- |  | - | ----- | 
|Available-for-Sale Securities:                            |  |         |       |  |         |   |         |         |  |   |       | 
|Obligations of U.S. Government Corporations and Agencies: |  |         |       |  |         |   |         |         |  |   |       | 
|Mortgaged-backed                                          |  | $       | 0     |  |         | $ | 51,685  |         |  | $ | 0     | 
|Other                                                     |  |         | 0     |  |         |   | 15,443  |         |  |   | 0     | 
|Obligations of state and political subdivisions           |  |         | 0     |  |         |   | 185,274 |         |  |   | 0     | 
|Corporate securities                                      |  |         | 0     |  |         |   | 54,296  |         |  |   | 0     | 
|Marketable equity securities                              |  |         | 1,834 |  |         |   | 0       |         |  |   | 0     | 
|Restricted equity securities                              |  |         | 0     |  |         |   | 4,892   |         |  |   | 0     | 
|Total                                                     |  | $       | 1,834 |  |         | $ | 311,590 |         |  | $ | 0     | 



|December 31, 2011                                         |  |         |       |  |         |   |         |         |  |   |       | 
|--------------------------------------------------------- |  | ------- | ----- |  | ------- | - | ------- | ------- |  | - | ----- | 
|                                                          |  | Level 1 |       |  | Level 2 |   |         | Level 3 |  |   | Total | 
|Available-for-Sale Securities:                            |  |         |       |  |         |   |         |         |  |   |       | 
|Obligations of U.S. Government Corporations and Agencies: |  |         |       |  |         |   |         |         |  |   |       | 
|Mortgaged-backed                                          |  | $       | 0     |  |         | $ | 67,781  |         |  | $ | 0     | 
|Other                                                     |  |         | 0     |  |         |   | 13,275  |         |  |   | 0     | 
|Obligations of state and political subdivisions           |  |         | 0     |  |         |   | 186,785 |         |  |   | 0     | 
|Corporate securities                                      |  |         | 0     |  |         |   | 59,242  |         |  |   | 0     | 
|Marketable equity securities                              |  |         | 1,741 |  |         |   | 0       |         |  |   | 0     | 
|Restricted equity securities                              |  |         | 0     |  |         |   | 5,189   |         |  |   | 0     | 
|Total                                                     |  | $       | 1,741 |  |         | $ | 332,272 |         |  | $ | 0     | 



The estimated fair values of equity securities
classified as Level 1 are derived from quoted market prices in active markets; these assets consist mainly of stocks held in other
banks. The estimated fair values of all debt securities classified as Level 2 are obtained from nationally-recognized third-party
pricing agencies. The estimated fair values are derived primarily from cash flow models, which include assumptions for interest
rates, credit losses, and prepayment speeds. The significant inputs utilized in the cash flow models are based on market data obtained
from sources independent of the Corporation (observable inputs), and are therefore classified as Level 2 within the fair value
hierarchy. The Corporation does not have any Level 3 inputs for investments. There were no transfers between Level 1 and Level
2 during 2012 and 2011.



Financial Assets Measured at Fair Value on a Nonrecurring
Basis



At June 30, 2012 and December 31, 2011,
impaired loans measured at fair value on a non-recurring basis and the valuation methods used are as follows:



|                        |  | Level 1 |   |  | Level 2 |   |   | Level 3 |  |   | Total | 
|----------------------- |  | ------- | - |  | ------- | - | - | ------- |  | - | ----- | 
|Assets at June 31, 2012 |  |         |   |  |         |   |   |         |  |   |       | 
|Impaired loans:         |  |         |   |  |         |   |   |         |  |   |       | 
|Commercial              |  | $       | 0 |  |         | $ | 0 |         |  | $ | 611   | 
|Commercial real estate  |  |         | 0 |  |         |   | 0 |         |  |   | 3,070 | 
|Residential             |  |         | 0 |  |         |   | 0 |         |  |   | 584   | 
|Total impaired loans    |  | $       | 0 |  |         | $ | 0 |         |  | $ | 4,265 | 





27







|                            |  | Level 1 |   |  | Level 2 |   |   | Level 3 |  |   | Total | 
|--------------------------- |  | ------- | - |  | ------- | - | - | ------- |  | - | ----- | 
|Assets at December 31, 2011 |  |         |   |  |         |   |   |         |  |   |       | 
|Impaired loans:             |  |         |   |  |         |   |   |         |  |   |       | 
|Commercial                  |  | $       | 0 |  |         | $ | 0 |         |  | $ | 123   | 
|Commercial real estate      |  |         | 0 |  |         |   | 0 |         |  |   | 3,210 | 
|Residential                 |  |         | 0 |  |         |   | 0 |         |  |   | 855   | 
|Total impaired loans        |  | $       | 0 |  |         | $ | 0 |         |  | $ | 4,188 | 



The Bank’s impaired loan valuation
procedure for any loans greater than $250,000 requires an appraisal to be obtained and reviewed annually at year end. A quarterly
collateral evaluation is performed which may include a site visit, property pictures and discussions with realtors and other similar
business professionals to ascertain current values. For impaired loans less than $250,000 upon classification and annually at year
end, the Bank completes a Certificate of Inspection, which includes an onsite inspection, insured values, tax assessed values,
recent sales comparisons and a review of the previous evaluations. These assets are included as Level 3 fair values, based upon
the lowest level that is significant to the fair value measurements. There were no transfers between valuation levels in 2012 and
2011.



Nonfinancial Assets Measured at Fair Value on a Nonrecurring
Basis



At June 30, 2012 and December 31, 2011,
foreclosed assets held for resale measured at fair value on a non-recurring basis and the valuation methods used are as follows:



|                                         |  |         |   |  |         |   |   |         |  |   |       | 
|---------------------------------------- |  | ------- | - |  | ------- | - | - | ------- |  | - | ----- | 
|                                         |  | Level 1 |   |  | Level 2 |   |   | Level 3 |  |   | Total | 
|Assets at June 31, 2012                  |  |         |   |  |         |   |   |         |  |   |       | 
|Other foreclosed assets held for resale: |  |         |   |  |         |   |   |         |  |   |       | 
|Residential real estate                  |  | $       | 0 |  |         | $ | 0 |         |  | $ | 338   | 
|Commercial real estate                   |  |         | 0 |  |         |   | 0 |         |  |   | 748   | 
|Total foreclosed assets held for resale  |  | $       | 0 |  |         | $ | 0 |         |  | $ | 1,086 | 



|                                         |  | Level 1 |   |  | Level 2 |   |   | Level 3 |  |   | Total | 
|---------------------------------------- |  | ------- | - |  | ------- | - | - | ------- |  | - | ----- | 
|Assets at December 31, 2011              |  |         |   |  |         |   |   |         |  |   |       | 
|Other foreclosed assets held for resale: |  |         |   |  |         |   |   |         |  |   |       | 
|Commercial real estate                   |  | $       | 0 |  |         | $ | 0 |         |  | $ | 780   | 
|Total foreclosed assets held for resale  |  | $       | 0 |  |         | $ | 0 |         |  | $ | 780   | 



The Bank’s foreclosed asset valuation
procedure requires an appraisal to be completed periodically with the exception of those cases which the Bank has obtained a sales
agreement. These assets are included as Level 3 fair values, based upon the lowest level that is significant to the fair value
measurements. There were no transfers between valuation levels in 2012 and 2011.





28







Fair Value of Financial Instruments



(Amounts in thousands)

|                                                  |  | Carrying |         |  | Fair Value Measurements at June 30, 2012 |  
|------------------------------------------------- |  | -------- | ------- |  | ---------------------------------------- | -
|                                                  |  | Amount   |         |  | Level 1                                  |  
|FINANCIAL ASSETS:                                 |  |          |         |  |                                          |  
|Cash and due from banks                           |  | $        | 8,462   |  |                                          | $
|Short-term investments                            |  |          | 2,967   |  |                                          |  
|Investment securities – available-for-sale        |  |          | 313,424 |  |                                          |  
|Investment securities – held-to-maturity          |  |          | 2,591   |  |                                          |  
|Net loans                                         |  |          | 413,814 |  |                                          |  
|Mortgage servicing rights                         |  |          | 440     |  |                                          |  
|Accrued interest receivable                       |  |          | 4,104   |  |                                          |  
|Cash surrender value of bank owned life insurance |  |          | 19,512  |  |                                          |  
|                                                  |  |          |         |  |                                          |  
|FINANCIAL LIABILITIES:                            |  |          |         |  |                                          |  
|Deposits                                          |  |          | 610,618 |  |                                          |  
|Short-term borrowings                             |  |          | 39,658  |  |                                          |  
|Long-term borrowings                              |  |          | 50,557  |  |                                          |  
|Accrued interest payable                          |  |          | 582     |  |                                          |  
|                                                  |  |          |         |  |                                          |  
|OFF-BALANCE SHEET FINANCIAL INSTRUMENTS:          |  |          |         |  |                                          |  
|Commitments to extend credit                      |  |          |         |  |                                          |  
|Financial standby letters of credit               |  |          |         |  |                                          |  
|Performance standby letters of credit             |  |          |         |  |                                          |  





(Amounts in thousands)

|                                                  |  | Carrying |         |  | Fair Value Measurements at December 31, 2011 |  
|------------------------------------------------- |  | -------- | ------- |  | -------------------------------------------- | -
|                                                  |  | Amount   |         |  | Level 1                                      |  
|FINANCIAL ASSETS:                                 |  |          |         |  |                                              |  
|Cash and due from banks                           |  | $        | 8,403   |  |                                              | $
|Short-term investments                            |  |          | 1,776   |  |                                              |  
|Investment securities – available-for-sale        |  |          | 334,013 |  |                                              |  
|Investment securities – held-to-maturity          |  |          | 2,605   |  |                                              |  
|Net loans                                         |  |          | 410,066 |  |                                              |  
|Mortgage servicing rights                         |  |          | 421     |  |                                              |  
|Accrued interest receivable                       |  |          | 4,375   |  |                                              |  
|Cash surrender value of bank owned life insurance |  |          | 19,145  |  |                                              |  
|                                                  |  |          |         |  |                                              |  
|FINANCIAL LIABILITIES:                            |  |          |         |  |                                              |  
|Deposits                                          |  |          | 624,349 |  |                                              |  
|Short-term borrowings                             |  |          | 30,882  |  |                                              |  
|Long-term borrowings                              |  |          | 64,339  |  |                                              |  
|Accrued interest payable                          |  |          | 785     |  |                                              |  
|                                                  |  |          |         |  |                                              |  
|OFF-BALANCE SHEET FINANCIAL INSTRUMENTS:          |  |          |         |  |                                              |  
|Commitments to extend credit                      |  |          |         |  |                                              |  
|Financial standby letters of credit               |  |          |         |  |                                              |  
|Performance standby letters of credit             |  |          |         |  |                                              |  



FASB ASC 825-10-50, Financial Instruments
- Overall - Disclosure, requires disclosure of fair value information about financial instruments, whether or not required
to be recognized in the consolidated balance sheets, for which it is practicable to estimate such fair value. In cases where quoted
market prices are not available, fair values are based on estimates using present value or other valuation techniques. These techniques
are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. Fair value
estimates derived through these techniques cannot be substantiated by comparison to independent markets and, in many cases, could
not be realized in immediate settlement of the instrument. FASB ASC 825-10-50 excludes certain financial instruments and all nonfinancial
instruments from its disclosure requirements. Accordingly, the aggregate fair value amounts presented do not represent the underlying
value of the Corporation.





29







The following methods and assumptions were
used by the Corporation in estimating its fair value disclosures for financial instruments:



Cash and Due From Banks, Short-Term Investments,
Accrued Interest Receivable and Accrued Interest Payable



The fair values are equal to the
current carrying values.



Investment Securities



Fair values have been individually
determined based on currently quoted market prices. If a quoted market price is not available, fair value is estimated using quoted
market prices for similar securities.



Loans



Fair values are estimated for
categories of loans with similar financial characteristics. Loans were segregated by type such as commercial, tax-exempt, real
estate mortgages and consumer. For estimation purposes, each loan category was further segmented into fixed and adjustable rate
interest terms and also into performing and non-performing classifications.



The fair value of each category
of performing loans is calculated by discounting future cash flows using the current rates at which similar loans would be made
to borrowers with similar credit ratings and for the same remaining maturities.



Fair value for non-performing
loans is based on management’s estimate of future cash flows discounted using a rate commensurate with the risk associated
with the estimated future cash flows. The assumptions used by management are judgmentally determined using specific borrower information.



Cash Surrender Value of Bank Owned Life
Insurance



Fair value is equal to the cash
surrender value of life insurance policies.



Deposits



Under FASB ASC 825-10-50, the
fair value of deposits with no stated maturity, such as demand deposits, savings accounts and money market accounts, is equal to
the amount payable on demand at June 30, 2012 and December 31, 2011.



Fair values for fixed-rate certificates
of deposit are estimated using a discounted cash flow calculation that applies interest rates currently being offered on similar
term borrowings, to a schedule of aggregated expected monthly maturities on time deposits.



Short-Term and Long-Term Borrowings



The fair values of short-term
borrowings are equal to the current carrying values, and long-term borrowings are estimated using discounted cash flow analyses
based on the Corporation’s incremental borrowing rate for similar instruments.



Commitments to Extend Credit and Standby
Letters of Credit



Management estimates that there
are no material differences between the notional amount and the estimated fair value of those off-balance sheet items since they
are primarily composed of unfunded loan commitments which are generally priced at market at the time of approval.





30







NOTE 9 — MANAGEMENT’S ASSERTIONS AND
COMMENTS REQUIRED TO BE PROVIDED WITH FORM 10-Q FILING



In management’s opinion, the consolidated
interim financial statements reflect fair presentation of the consolidated financial position of First Keystone Corporation and
Subsidiary, and the results of their operations and their cash flows for the interim periods presented. Further, the consolidated
interim financial statements are unaudited; however they reflect all adjustments, which are in the opinion of management, necessary
to present fairly the consolidated financial condition and consolidated results of operations and cash flows for the interim periods
presented and that all such adjustments to the consolidated financial statements are of a normal recurring nature. The independent
registered public accounting firm, J. H. Williams & Co., LLP, reviewed these consolidated financial statements as stated in
their accompanying review report.



The results of operations for the six-month
period ended June 30, 2012, are not necessarily indicative of the results to be expected for the full year.



These consolidated interim financial statements
have been prepared in accordance with requirements of Form 10-Q and therefore do not include all disclosures normally required
by accounting principles generally accepted in the United States of America applicable to financial institutions as included with
consolidated financial statements included in the Corporation’s Annual Report on Form 10-K filing. The reader of these consolidated
interim financial statements may wish to refer to the Corporation’s Annual Report on Form 10-K for the period ended December
31, 2011, filed with the Securities and Exchange Commission.





31







REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM



Board of Directors and Stockholders of First Keystone Corporation:





We have reviewed the consolidated balance sheet of First Keystone
Corporation and Subsidiary as of June 30, 2012 and the related consolidated statements of income, changes in stockholders’
equity, and comprehensive income for the three and six month periods ended June 30, 2012 and 2011 and cash flows for the six-month
periods ended June 30, 2012 and 2011. These consolidated interim financial statements are the responsibility of the management
of First Keystone Corporation and Subsidiary.



We conducted our review in accordance with the standards of
the Public Company Accounting Oversight Board (United States). A review of interim financial information consists principally of
applying analytical procedures and making inquiries of persons responsible for financial and accounting matters. It is substantially
less in scope than an audit conducted in accordance with standards of the Public Company Accounting Standards Board (United States),
the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do
not express such an opinion.



Based on our reviews, we are not aware of any material modifications
that should be made to the accompanying consolidated interim financial statements referred to above for them to be in conformity
with accounting principles generally accepted in the United States of America.



We have previously audited, in accordance with auditing standards
of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet of First Keystone Corporation
as of December 31, 2011, and the related consolidated statements of income, changes in stockholders’ equity, and cash flows
for the year then ended (not presented herein); and in our report dated March 15, 2012, we expressed an unqualified opinion on
those consolidated financial statements. In our opinion, the information set forth in the accompanying consolidated balance sheet
as of December 31, 2011, is fairly stated, in all material respects, in relation to the consolidated balance sheet from which it
has been derived.





/s/ J. H. Williams & Co., LLP

J. H. Williams & Co., LLP





Kingston, Pennsylvania

August 8, 2012





32







Item 2. 	First Keystone Corporation Management’s Discussion
and Analysis of Financial Condition and Results of Operation as of June 30, 2012



This quarterly report contains certain forward-looking
statements, which are included pursuant to the “safeharbor” provisions of the Private Securities Litigation Reform
Act of 1995, and reflect management’s beliefs and expectations based on information currently available. These forward-looking
statements are inherently subject to significant risks and uncertainties, including changes in general economic and financial market
conditions, the Corporation’s ability to effectively carry out its business plans and changes in regulatory or legislative
requirements. Other factors that could cause or contribute to such differences are changes in competitive conditions, and pending
or threatened litigation. Although management believes the expectations reflected in such forward-looking statements are reasonable,
actual results may differ materially.



RESULTS OF OPERATIONS



First Keystone Corporation realized earnings
for the second quarter of 2012 of $2,578,000, an increase of $35,000, or 1.4% from the second quarter of 2011. The increase in
net income for 2012 was primarily the result of an increased net interest margin and an increase in net interest income of $259,000
from the second quarter of 2011. On a per share basis, net income per share was $.96 for the first six months of 2012 up from $.93
for the first six months of 2011, an increase of 3.2%. Cash dividends increased to $.50 per share up from $.48 in the first half
of 2011, an increase of 4.2%.



Year-to-date net income annualized as of
June 30, 2012, amounted to a return on average common equity of 10.78%, a return on tangible equity of 13.43% and a return on assets
of 1.26%. For the six months ended June 30, 2011, these measures were 12.48%, 16.35%, and 1.24%, respectively, on an annualized
basis.



In July 2012, the Corporation completed
transactions designed to improve net interest income. Investment securities with a market value of $15,941,000 and having a yield
of 2.95% were sold for a gain of $946,000. In addition, term borrowings with the Federal Home Loan Bank of Pittsburgh in the amount
of $13,750,000 with a weighted average cost of 4.29% were prepaid, resulting in a prepayment penalty of $811,000. The impact of
these transactions was an annualized increase in net interest income of $150,000. The deleveraging of the balance sheet also improved
Tier 1 leverage and improved sensitivity to rising interest rates.



NET INTEREST INCOME



The major source of operating income for
the Corporation is net interest income, defined as interest income less interest expense. In the second quarter of 2012, interest
income amounted to $8,841,000, a decrease of $489,000 or 5.2% from the second quarter of 2011, while interest expense amounted
to $1,715,000 in the second quarter of 2012, a decrease of $748,000, or 30.4% from the second quarter of 2011. As a result, net
interest income increased $259,000 or 3.8% in the second quarter of 2012 to $7,126,000 from $6,867,000 in second quarter of 2011.



Our net interest margin for the six months
ended June 30, 2012 was 4.09% compared to 3.97% for the six months ended June 30, 2011.



PROVISION FOR LOAN LOSSES



The provision for loan losses for the first
half of 2012, was $800,000, compared to $600,000 for the first half of 2011. The increase in the provision for loan losses resulted
from our analysis of the current loan portfolio, including historic losses, past-due trends, current economic conditions, and other
relevant factors. Net charge-offs for the six month period ended June 30, 2012 was $905,000, compared to $541,000 for the six month
period ended 2011. The allowance for loan losses as a percentage of average loans outstanding, net of unearned interest, was 1.39%
for the six months ended June 30, 2012, as compared to 1.39% for the six months ended June 30, 2011, and 1.44% for the year ended
December 31, 2011. See Allowance for Loan Losses on Page 36 for further discussion.





33







NON-INTEREST INCOME



Total non-interest income was $2,193,000
for the quarter ended June 30, 2012, as compared to $1,059,000 for the quarter ended June 30, 2011, an increase of $1,134,000,
or 107.1%. Excluding investment securities gains and losses, non-interest income was $1,216,000 for the second quarter of 2012,
an increase of $157,000, or 14.8% from the second quarter of 2011. The increase in non-interest income was driven by an increase
in net gains on the sale of investment securities of $977,000, an increase in gains on sale of residential mortgage loans of $192,000
and an increase in Trust Department income of $31,000 as compared to the second quarter of 2011.



NON-INTEREST EXPENSE



Total non-interest expense was $5,807,000
for the quarter ended June 30, 2012, as compared to $4,472,000 for the quarter ended June 30, 2011. The increase of $1,335,000,
or 29.9% is comprised of prepayment penalties on the early pay-off of several long-term borrowings of $811,000, salary and employee
benefits expense increasing $220,000, net occupancy, furniture and equipment, and computer expense increasing $55,000, and other
non-interest expense, including FDIC insurance, professional services and state shares tax increasing $249,000. These increases
reflect additional employee and benefit costs associated with a new office opening in Plymouth, Pennsylvania, in the third quarter
of 2011, and staffing additions to the accounting and the information security areas.



Expenses associated with employees (salaries
and employee benefits) continue to be the largest category of non-interest expense. Salaries and benefits amounted to $5,192,000,
or 50.0% of total non-interest expense for the six months ended June 30, 2012, as compared to 52.8% for the six months of 2011.
Net occupancy, furniture and equipment, and computer expense amounted to $1,440,000 for the six months ended June 30, 2012, an
increase of $75,000, or 5.5%. Other non-interest expense, including the FHLB prepayment penalty, FDIC insurance, professional services
and state shares tax amounted to $3,760,000 for the six months ended June 30, 2012, an increase of $982,000, or 35.3% from the
first six months of 2011. Non-interest expense in the first half of 2012 is approximately 2.5% of average assets on an annualized
basis, which places us among the leaders of our peer financial institutions at controlling total non-interest expense.



INCOME TAXES



Effective tax planning has helped produce
favorable net income. Income tax expense amounted to $1,117,000 for the six months ended June 30, 2012, as compared to $1,305,000
for the six months ended June 30, 2011, a decrease of $188,000. The effective total income tax rate was 17.2% for the second quarter
of 2012 as compared to 19.4% for the second quarter of 2011. The effective total income tax rate was 17.6% for the first half of
2012 as compared to 20.6% for the first half of 2011. The decrease in the effective tax rate was due to an additional tax credit
taken as a result of a low-income housing investment partnership acquired in 2010.



ANALYSIS OF FINANCIAL CONDITION



ASSETS



Total assets decreased to $806,208,000
as of June 30, 2012, a decrease of $12,338,000 from year-end 2011. Net loans increased by $3,748,000 or 0.9%, reflecting continued
weak demand. Cash balances remained nearly the same from year-end.



During the first half of 2012, the Corporation
increased short-term borrowings to $39,658,000 as of June 30, 2012, as compared to $30,882,000 as of December 31, 2011. Long-term
borrowings decreased to $50,557,000 as of June 30, 2012, down from the $64,339,000 as of December 31, 2011.



The decreases in total assets and long-term
borrowings were attributable to a program in which investments were sold to pay-off several long-term borrowings to further improve
net interest margin.





34







EARNING ASSETS



Our primary earning asset, loans, net of
unearned income, increased to $419,638,000 as of June 30, 2012, up $3,643,000, or 0.9% since year-end 2011. The loan portfolio
continues to be diversified. Overall asset quality has remained consistent with non-performing assets increasing since year-end
2011. Total non-performing assets were $5,540,000 as of June 30, 2012, an increase of $572,000, or 11.5% from the $4,968,000 reported
in non-performing assets as of December 31, 2011. Total allowance for loan losses to total non-performing assets was 105.1% as
of June 30, 2012 and 119.3% at December 31, 2011.



In addition to loans, another primary earning
asset is our overall investment portfolio, which decreased in size from

December 31, 2011, to June 30, 2012. Held-to-maturity securities
amounted to $2,591,000 as of June 30, 2012, a decrease of $14,000 from December 31, 2011. Available-for-sale securities amounted
to $313,424,000 as of June 30, 2012, a decrease of $20,589,000 from year-end 2011. Interest-bearing deposits in other banks increased
as of June 30, 2012, to $2,967,000 from $1,776,000 at year-end 2011.



LOANS



Total loans, net of unearned income, increased
to $419,638,000 as of June 30, 2012, as compared to a balance of $415,995,000 as of December 31, 2011. The table on page 19 provides
data relating to the composition of the Corporation’s loan portfolio on the dates indicated. Total loans, net of unearned
income, increased $3,643,000, or 0.9% in the first half of 2012.



The economy and the resultant decline in
loan demand accounted for slow growth in the loan portfolio in the first half of 2012. The Residential Real Estate loan portfolio
increased $6,471,000 to $137,189,000 as of June 30, 2012, as compared to $130,718,000 as of December 31, 2011. The majority of
the increase was the result of new originations and refinances held in the Bank’s portfolio. The Commercial Secured by Real
Estate loan portfolio decreased $8,048,000 to $228,597,000 as of June 30, 2012, as compared to $236,645,000 as of December 31,
2011. The decrease was the result of weak new loan originations; a $6,405,000 pay-off of one large commercial mortgage; pay-offs
of four commercial mortgages with balances of $450,000 or more (all of which were income-producing properties); and typical portfolio
run-off.



The loan portfolio is well diversified.
The total commercial portfolio was $275,661,000 at June 30, 2012 and $277,872,000 at December 31, 2011, of which $231,093,000 or
55.1% of gross loans were secured by commercial real estate at June 30, 2012, and $238,186,000 or 57.3% at December 31, 2011.



The largest relationship is an $8,387,000
tax-free loan to a municipality founded in 1816 consisting of 35 square miles, which is located in the eastern region of our market
area. According to township officials, the township experienced 17% growth in population from 2001 through 2010 and future job
growth is projected to be 29% over the next 10 years. The township is currently involved in a $70,000,000 sewer expansion project.
The Bank’s loan is secured by project receivables and the full faith, credit and taxing power of the township.



The second largest relationship consisted
of the net balance of $8,361,000 after participation shares sold of $3,166,000. This relationship is comprised of several first
lien mortgages relating to office and professional rental properties and a $5,000,000 line of credit to a planned residential community
in the Corporation’s eastern market area. The principal and related companies have been involved in real estate development
since 1974, and have successfully developed residential communities, medical office facilities, and professional office facilities.
The entire relationship is secured by a combination of real estate and marketable securities.



The third largest relationship of $7,325,000
is comprised of loans to individuals and their related companies involved in the ownership and operation of gas stations, convenience
stores, and truck stops located in northern, central and eastern Pennsylvania. The borrowers are well experienced in the industry
and have been operating various locations since 1988. The loans are secured by commercial real estate, and perfected security interest
in all business assets.



The fourth largest relationship is a real
estate development company and its related entities, specializing in the design, construction and management of student housing
units. The company was established in the late 1980s and its primary market is our immediate central market. The relationship had
outstanding loan balances of $7,035,000 at June 30, 2012, and is secured primarily by income producing real estate.





35







The fifth largest relationship is a real
estate holding LLC established in 2006 along with its related medical service companies. The LLC was formed to construct and provide
medical office space for a group of closely related medical entities and outside services and is located in the Corporation’s
immediate central market area. The relationship had outstanding loan balances of $6,916,000 at June 30, 2012, secured primarily
by commercial real estate and perfected security interest in all business assets of the various related entities.



Each of the aforementioned loans are paying
as agreed and none of the loans are considered criticized or classified. The property securing each of the loans was appraised
at the time the loan was originated. Appraisals are ordered independently of the loan approval process from appraisers on an approved
list. All appraisals are reviewed internally for conformity with accepted standards of the Bank.



All loan relationships in excess of $1,500,000
are reviewed internally and through an external loan review process on an annual basis. Such review is based upon analysis of current
financial statements of the borrower, co-borrowers/guarantors, payment history, and economic conditions.



Increases in the portfolio in the first
half of 2012 were primarily in residential mortgage real estate loans. There was an increase in commercial loans – other;
these are loans to corporations and businesses not secured by real estate. The Corporation continued to originate and sell certain
long-term fixed rate residential mortgage loans which conform to secondary market requirements. The Corporation derives ongoing
income from the servicing of mortgages sold in the secondary market.



The Corporation continues to internally
underwrite each of its loans to comply with prescribed policies and approval levels established by its Board of Directors.



Loans Outstanding, Net of Unearned Income



|(Amounts in thousands)                             |  | June 30, |         |  | December 31, |  
|-------------------------------------------------- |  | -------- | ------- |  | ------------ | -
|                                                   |  | 2012     |         |  | 2011         |  
|Commercial, financial and agricultural:            |  |          |         |  |              |  
|Commercial secured by real estate                  |  | $        | 228,597 |  |              | $
|Commercial - other                                 |  |          | 24,853  |  |              |  
|Tax exempt - real estate and other                 |  |          | 22,211  |  |              |  
|Real estate (primarily residential mortgage loans) |  |          | 137,189 |  |              |  
|Consumer loans                                     |  |          | 6,697   |  |              |  
|Total Gross Loans                                  |  |          | 419,547 |  |              |  
|Add (deduct): Unearned discount and                |  |          |         |  |              |  
|Net deferred loan fees and costs                   |  |          | 91      |  |              |  
|Total Loans, net of unearned income                |  | $        | 419,638 |  |              | $



ALLOWANCE FOR LOAN LOSSES



The allowance for loan losses constitutes
the amount available to absorb losses within the loan portfolio. As of June 30, 2012, the allowance for loan loss was $5,824,000
as compared to $5,929,000 as of December 31, 2011. The allowance for loan losses is established through a provision for loan losses
charged to expenses. Loans are charged against the allowance for possible loan losses when management believes that the collectability
of the principal is unlikely. The risk characteristics of the loan portfolio are managed through the various control processes,
including credit evaluations of individual borrowers, periodic reviews, and diversification by industry. Risk is further mitigated
through the application of lending procedures such as the holding of adequate collateral and the establishment of contractual guarantees.



Management performs a quarterly analysis
to determine the adequacy of the allowance for loan losses. The methodology in determining adequacy incorporates specific and general
allocations together with a risk/loss analysis on various segments of the portfolio according to an internal loan review process.
This assessment results in an allocated allowance. Management maintains its loan review and loan classification standards consistent
with those of its regulatory supervisory authority.



Management considers, based upon its methodology,
that the allowance for loan losses is adequate to cover foreseeable future losses. However, there can be no assurance that the
allowance for loan losses will be adequate to cover significant losses, if any, that might be incurred in the future.





36







The Analysis of Allowance for Loan Losses
table contains an analysis of our Allowance for Loan Losses indicating charge-offs and recoveries for the six month period and
the year and additional provisions charged to operations. In the first six months of 2012, net charge-offs as a percentage of average
loans were 0.22%, as compared to net charge-offs as a percentage of average loans of 0.41% during the twelve months of 2011, and
0.26% for the first six months of 2011. Net charge-offs amounted to $905,000 for the first six months of 2012 as compared to $1,672,000
for the twelve months ended December 31, 2011, and $541,000 for the first six months of 2011. The increase in net charge-offs in
the first six months of 2012 as compared to the first six months of 2011 relates primarily to one commercial real estate relationship
that was charged down $300,000 or 33.1% of net charge-offs; one Commercial/Financial relationship that was written down $153,000
or 16.9% of net charge-offs; and two Residential Mortgages that were charged down $169,000 or 18.7% of net charge-offs. The remaining
balance of net charge-offs was comprised of small commercial relationships and small consumer loans.





For the first half of 2012, the provision
for loan losses was $800,000 as compared to $600,000 for the first half of 2011. The provision, net of charge-offs and recoveries,
increased the quarter end Allowance for Loan Losses to $5,824,000 of which $446,000 or 7.7% is attributed to Commercial, financial
and agriculture loans; $4,578,000 or 78.6% is attributed to Real Estate loans; $111,000 or 1.9% is attributed to Consumer loans,
and $689,000 or 11.8% being the unallocated component (refer to the activity in the allowance for loan losses by loan segment table
in Note 3 — Loans on page 19). The Allowance for Loan Losses decreased to $5,824,000 as of June 30, 2012, as compared to
$5,929,000 as of December 31, 2011. The Corporation determined that the provision for loan losses made during the current quarter
was sufficient to maintain the allowance for loan losses at a level necessary for probable losses inherent in the loan portfolio
as of June 30, 2012.





Analysis of Allowance for Loan Losses



|(Amounts in thousands)                        |  |          |       |   |              |   |       |          | 
|--------------------------------------------- |  | -------- | ----- | - | ------------ | - | ----- | -------- | 
|                                              |  | June 30, |       |   | December 31, |   |       | June 30, | 
|                                              |  | 2012     |       |   | 2011         |   |       | 2011     | 
|Balance at beginning of period                |  | $        | 5,929 |   |              | $ | 5,701 |          | 
|Charge-offs:                                  |  |          |       |   |              |   |       |          | 
|Commercial, financial and agricultural        |  |          | 243   |   |              |   | 485   |          | 
|Real estate                                   |  |          | 691   |   |              |   | 1,186 |          | 
|Consumer                                      |  |          | 28    |   |              |   | 98    |          | 
|                                              |  |          | 962   |   |              |   | 1,769 |          | 
|Recoveries:                                   |  |          |       |   |              |   |       |          | 
|Commercial, financial and agricultural        |  |          | 15    |   |              |   | 28    |          | 
|Real estate                                   |  |          | 21    |   |              |   | 53    |          | 
|Consumer                                      |  |          | 21    |   |              |   | 16    |          | 
|                                              |  |          | 57    |   |              |   | 97    |          | 
|                                              |  |          |       |   |              |   |       |          | 
|Net charge-offs                               |  |          | 905   |   |              |   | 1,672 |          | 
|Additions charged to operations               |  |          | 800   |   |              |   | 1,900 |          | 
|Balance at end of period                      |  | $        | 5,824 |   |              | $ | 5,929 |          | 
|                                              |  |          |       |   |              |   |       |          | 
|Ratio of net charge-offs during the period to |  |          |       |   |              |   |       |          | 
|average loans outstanding during the period   |  |          | 0.22  | % |              |   | 0.41  | %        | 
|Allowance for loan losses to average loans    |  |          |       |   |              |   |       |          | 
|outstanding during the period                 |  |          | 1.39  | % |              |   | 1.44  | %        | 



It is the policy of management and the Corporation’s
Board of Directors to make a provision for both identified and unidentified losses inherent in its loan portfolio. A provision
for loan losses is charged to operations based upon an evaluation of the potential losses in the loan portfolio. This evaluation
takes into account such factors as portfolio concentrations, delinquency trends, trends of non-accrual and classified loans, economic
conditions, and other relevant factors.



The loan review process, which is conducted
quarterly, is an integral part of the Bank’s evaluation of the loan portfolio. A detailed quarterly analysis to determine
the adequacy of the Corporation’s allowance for loan losses is reviewed by the Board of Directors.





37







With our manageable level of net charge-offs
and the additions to the reserve from our provision out of operations, the allowance for loan losses as a percentage of average
loans amounted to 1.39% at June 30, 2012, 1.44% at December 31, 2011 and 1.39% at June 30, 2011.



The following table sets forth the allocation
of the Bank’s allowance for loan losses by loan category and the percentage of loans in each category to total loans receivable
at the dates indicated. The portion of the allowance for loan losses allocated to each loan category does not represent the total
available for future losses that may occur within the loan category, since the total loan loss allowance is a valuation reserve
applicable to the entire loan portfolio.



Allocation of Allowance for Loan Losses



|(Amounts in thousands)                 |  | June 30, |       |  | December 31, | 
|-------------------------------------- |  | -------- | ----- |  | ------------ | 
|                                       |  | 2012     |       |  | 2011         | 
|Commercial, financial and agricultural |  | $        | 446   |  |              | 
|Real estate - mortgage                 |  |          | 4,578 |  |              | 
|Consumer and other loans               |  |          | 111   |  |              | 
|Unallocated                            |  |          | 689   |  |              | 
|                                       |  | $        | 5,824 |  |              | 

______________________

*Percentage of allocation in each category to total in the Allowance
for Loan Loss Analysis, excluding unallocated.





NON-PERFORMING ASSETS



The “Non-Performing Assets”
table on page 40 details the Corporation’s non-performing assets as of the dates indicated. Generally, a loan is classified
as non-accrual and the accrual of interest on such a loan is discontinued when the contractual payment of principal or interest
has become 90 days past due or management has serious doubts about further collectability of principal or interest, even though
the loan currently is performing. A loan may remain on accrual status if it is in the process of collection and is either guaranteed
or well secured. When a loan is placed on non-accrual status, unpaid interest credited to income in the current year is reversed
and unpaid interest accrued in prior years is charged against income. Restructured loans are loans where the borrower has been
granted a concession in the interest rate or payment amount because of financial problems. Foreclosed assets held for resale represent
property acquired through foreclosure, or considered to be an in-substance foreclosure.



Total non-performing assets increased $572,000
to $5,540,000 as of June 30, 2012 as compared to $4,968,000 as of December 31, 2011. The economy, in particular, high unemployment,
weak job markets, unsettled fuel prices, rising energy costs, and the continued slowness in the housing industry had a direct effect
of increasing the Corporation’s non-performing assets. The Corporation is closely monitoring its commercial real estate portfolio
because of the current economic environment. In particular, vacancy rates are rising and rents and property values in some markets
have fallen. Losses on commercial real estate, which increased in 2011, are projected to continue at higher than average levels
into 2012. Impaired loans increased to $4,265,000 as of June 30, 2012, as compared to $4,188,000 as of December 31, 2011. Foreclosed
assets held for resale increased to $1,086,000 as of June 30, 2012 as compared to $780,000 as of December 31, 2011. Loans past-due
90 days or more and still accruing interest increased to $189,000 as of June 30, 2012, as compared to $0 as of December 31, 2011.
These loans are deemed to be well secured and in the process of collection. Non-performing assets to period end loans and foreclosed
assets was 1.3% as of June 30, 2012 and 1.2% as of December 31, 2011. Total non-performing assets to total assets was 0.7% as of
June 30, 2012 and 0.6% as of December 31, 2011. Our allowance for loan losses to total non-performing assets was 105.1% as of June
30, 2012 and 119.3% as of December 31, 2011. Additional detail can be found on page 40, “Non-Performing Assets Table”
and page 24 in the “Financing Receivables on Non-Accrual Status Table”. Asset quality is a priority and the Corporation
retains a full-time Loan Review Officer to closely track and monitor overall loan quality, along with a full-time workout specialist
to manage collection and liquidation efforts.



Impaired loans increased to $4,265,000 at
June 30, 2012 from $4,188,000 at December 31, 2011. Five relationships carried aggregate balances of $250,000 or greater. The largest
relationship is represented by five loans carrying a balance of $1,147,000 secured by rental residential real estate. The June
30, 2012 valuation carried a net realizable value of $1,037,000, after an estimated $94,000 cost to sell, resulting in a specific
allocation of $110,000. The second largest relationship is represented by two loans carrying a balance of $988,000 secured by commercial
real estate and business assets. The June 30, 2012 valuation carried a net realizable value of $595,000, after an estimated $105,000
cost to sell, resulting in a specific allocation of $393,000. The third largest relationship is represented by two loans carrying
a balance of $286,000 secured by leasehold mortgages. The June 30, 2012 valuation carried a net realizable value of $148,000, after
an estimated $53,000 cost to sell, resulting in a specific allocation of $138,000. The fourth largest relationship is represented
by two loans carrying a balance of $257,000 secured by commercial real estate and business assets. The June 30, 2012 valuation
carried a net realizable value of $360,000, after an estimated $40,000 cost to sell, resulting in a specific allocation of $0.
The fifth largest relationship is represented by one loan carrying a balance of $253,000 secured by residential/farm property with
acreage. The June 30, 2012 valuation carried a net realizable value of $194,000, after an estimated $22,000 cost to sell, resulting
in a specific allocation of $59,000. Of the $4,265,000 in impaired loans, $286,000 is located outside of our primary market area.
None of the impaired loans are participated facilities.





38







The Corporation’s impaired loan valuation
procedure for any loans greater than $250,000 requires an appraisal to be obtained and reviewed annually at year end. A quarterly
collateral evaluation is performed which may include a site visit, property pictures and discussions with realtors and other similar
business professionals to ascertain current values.



For impaired loans less than $250,000 upon
classification and annually at year end, the Corporation completes a Certificate of Inspection, which includes the results of an
onsite inspection, insured values, tax assessed values, recent sales comparisons and a review of the previous evaluations.



Improving loan quality is a priority, and
we actively work with borrowers to resolve credit problems and will continue our close monitoring efforts in 2012. As of June 30,
2012, the Corporation did not have any troubled debt restructurings in its loan portfolio. Excluding the assets disclosed in the
Non-Performing Assets Table, management is not aware of any information about borrowers’ possible credit problems which cause
serious doubt as to their ability to comply with present loan repayment terms.



Should the economic climate no longer continue
to be stable or deteriorate further, borrowers may experience difficulty, and the level of non-performing loans and assets, charge-offs
and delinquencies could rise and possibly require additional increases in the Corporation’s allowance for loan losses.



In addition, regulatory authorities, as
an integral part of their examinations, periodically review the allowance for possible loan and lease losses. They may require
additions to allowances based upon their judgments about information available to them at the time of examination.



Interest income received and accrued on
non-performing loans in the first half of 2012 and for the year ended December 31, 2011 was $10,000 and $54,000, respectively.
Interest income, which would have been recorded on these loans under the original terms as of June 30, 2012 and December 31, 2011,
was $188,000 and $342,000, respectively. At June 30, 2012 and December 31, 2011, the Corporation had no outstanding commitments
to advance additional funds with respect to these non-performing loans.



A concentration of credit exists when the
total amount of loans to borrowers, who are engaged in similar activities that are similarly impacted by economic or other conditions,
exceed 10% of total loans. As of June 30, 2012 and December 31, 2011, management is of the opinion that there were no loan concentrations
exceeding 10% of total loans.





39







Non-performing Assets



(Amounts in thousands)

|                                                                |  | June 30, |       |   | December 31, |  
|--------------------------------------------------------------- |  | -------- | ----- | - | ------------ | -
|                                                                |  | 2012     |       |   | 2011         |  
|Non-performing assets                                           |  |          |       |   |              |  
|Impaired loans                                                  |  | $        | 4,265 |   |              | $
|Foreclosed assets held for resale                               |  |          | 1,086 |   |              |  
|Loans past-due 90 days or more and still accruing interest      |  |          | 189   |   |              |  
|Total non-performing assets                                     |  | $        | 5,540 |   |              | $
|                                                                |  |          |       |   |              |  
|Impaired loans                                                  |  |          |       |   |              |  
|Non-performing loans                                            |  | $        | 4,265 |   |              | $
|Allocated allowance for loan losses                             |  |          | (921  | ) |              |  
|Net investment in impaired loans                                |  | $        | 3,344 |   |              | $
|                                                                |  |          |       |   |              |  
|Impaired loans with a valuation allowance                       |  | $        | 2,963 |   |              | $
|Impaired loans without a valuation allowance                    |  |          | 1,302 |   |              |  
|Total impaired loans                                            |  | $        | 4,265 |   |              | $
|                                                                |  |          |       |   |              |  
|Allocated valuation allowance related to impaired loans         |  | $        | 921   |   |              | $
|                                                                |  |          |       |   |              |  
|Allocated valuation allowance as a percent of impaired loans    |  |          | 21.6  | % |              |  
|Impaired loans to loans net of unearned discount                |  |          | 1.0   | % |              |  
|Non-performing assets to period-end loans and foreclosed assets |  |          | 1.3   | % |              |  
|Total non-performing assets to total assets                     |  |          | 0.7   | % |              |  
|Allowance for loan losses to impaired loans                     |  |          | 136.6 | % |              |  
|Allowance for loan losses to total non-performing assets        |  |          | 105.1 | % |              |  



Real estate mortgages comprise 87.8% of
the net loan portfolio as of June 30, 2012, as compared to 88.7% as of December 31, 2011. Real estate mortgages consist of both
residential and commercial real estate loans. The real estate loan portfolio is well diversified in terms of borrowers, collateral,
interest rates, and maturities. Also, the residential real estate loan portfolio is largely fixed rate mortgages. The real estate
loans are concentrated primarily in our market area and are subject to risks associated with the local economy. The commercial
real estate loans typically re-price approximately each three to five years and are also concentrated in our market area. The Corporation’s
loss exposure on its non-performing loans continues to be mitigated by collateral positions on these loans. The allocated allowance
for loan losses associated with impaired loans is generally computed based upon the related collateral value of the loans. The
collateral values are determined by recent appraisals, but are generally discounted by management based on historical dispositions,
changes in market conditions since the last valuation and management’s expertise and knowledge of the borrower and the borrower’s
business.



DEPOSITS AND OTHER BORROWED FUNDS



Total deposits decreased $13,731,000 to
$610,618,000 as of June 30, 2012 as non-interest bearing deposits increased by $9,683,000 and interest bearing deposits decreased
by $23,414,000 as of June 30, 2012, from year-end 2011. Total short-term and long-term borrowings decreased to $90,215,000 as of
June 30, 2012, from $95,221,000 at year-end 2011, a decrease of $5,006,000, or 5.3%.



CAPITAL STRENGTH



Normal increases in capital are generated
by net income, less cash dividends paid out. Also, accumulated other comprehensive income derived from unrealized gains on investment
securities available-for-sale increased stockholders’ equity, or capital net of taxes, by $3,001,000 for the six months ended
June 30, 2012. The Corporation had 241,730 and 242,517 shares of common stock on June 30, 2012 and December 31, 2011, respectively,
as treasury stock. This had an effect of reducing our total stockholders’ equity by $6,042,000 as of June 30, 2012, and $6,069,000
as of December 31, 2011.





40







Total stockholders’ equity was $98,616,000
as of June 30, 2012, and $93,092,000 as of December 31, 2011. Leverage ratio and risk based capital ratios remain very strong.
As of June 30, 2012, our leverage ratio was 8.41% compared to 8.07% as of December 31, 2011. In addition, Tier I risk based capital
and total risk based capital ratio as of June 30, 2012, were 12.60% and 13.70%, respectively. The same ratios as of December 31,
2011 were 11.99% and 13.09%, respectively.



At its Annual Shareholders’ Meeting
on May 10, 2012, the Corporation’s Articles of Incorporation were amended to increase the number of authorized common shares
with a par value of $2.00 from 10,000,000 to 20,000,000 shares. Additionally, the Corporation was authorized to issue up to 1,000,000
shares of preferred stock on terms to be determined by the Board of Directors.





LIQUIDITY



The liquidity position of the Corporation
remains adequate to meet customer loan demand and deposit fluctuation. Managing liquidity remains an important segment of asset/liability
management. Our overall liquidity position is maintained by an active asset/liability management committee.



Management feels its current liquidity position
is satisfactory given the fact that the Corporation has a very stable core deposit base which has increased annually. Secondly,
the Corporation’s loan payments and principal paydowns on its mortgage backed securities provide a steady source of funds.
Also, short-term investments and maturing investments represent additional sources of liquidity.



The following table represents scheduled
maturities of the Corporation’s contractual obligations by time remaining until maturity as of June 30, 2012 and December
31, 2011.





(Amounts in thousands)

|                                                         |  | Less than |         |  | 1 - 3 |   |        | 3 - 5 |  |   | Over    |  |  |       |       
|-------------------------------------------------------- |  | --------- | ------- |  | ----- | - | ------ | ----- |  | - | ------- |  |  | ----- | ------
|Contractual Obligations June 30, 2012                    |  | 1 Year    |         |  | Years |   |        | Years |  |   | 5 Years |  |  | Total |       
|                                                         |  |           |         |  |       |   |        |       |  |   |         |  |  |       |       
|Time deposits                                            |  | $         | 144,246 |  |       | $ | 78,471 |       |  | $ | 27,601  |  |  | $     | 0     
|Securities sold under agreement to repurchase            |  |           | 18,503  |  |       |   | 0      |       |  |   | 0       |  |  |       | 0     
|FHLB borrowings                                          |  |           | 32,155  |  |       |   | 19,000 |       |  |   | 5,000   |  |  |       | 15,000
|Commitments to grant loans1                              |  |           | 6,528   |  |       |   | 0      |       |  |   | 0       |  |  |       | 0     
|Commitments to fund loans for secondary market mortgages |  |           | 961     |  |       |   | 0      |       |  |   | 0       |  |  |       | 0     
|Unfunded commitments on lines of credit1                 |  |           | 57,993  |  |       |   | 0      |       |  |   | 0       |  |  |       | 0     
|Financial standby letters of credit1                     |  |           | 756     |  |       |   | 0      |       |  |   | 0       |  |  |       | 0     
|Performance standby letters of credit1                   |  |           | 3,838   |  |       |   | 0      |       |  |   | 0       |  |  |       | 0     
|Purchase and building commitments                        |  |           | 3,120   |  |       |   | 0      |       |  |   | 0       |  |  |       | 0     
|Commitment for investment in real estate venture         |  |           | 180     |  |       |   | 0      |       |  |   | 0       |  |  |       | 0     
|Operating lease obligations                              |  |           | 170     |  |       |   | 271    |       |  |   | 196     |  |  |       | 2,360 
|Capital lease obligations                                |  |           | 135     |  |       |   | 454    |       |  |   | 229     |  |  |       | 0     
|                                                         |  | $         | 268,585 |  |       | $ | 98,196 |       |  | $ | 33,026  |  |  | $     | 17,360



1The Corporation does not expect all of the
commitments and letters of credit to be fully funded. The total commitments amount related to these contractual obligations
does not necessarily represent future cash requirements.





41







(Amounts in thousands)

|                                                         |  | Less than |         |  | 1 - 3 |   |         | 3 - 5 |  |   | Over    |  |  |       |      
|-------------------------------------------------------- |  | --------- | ------- |  | ----- | - | ------- | ----- |  | - | ------- |  |  | ----- | -----
|Contractual Obligations December 31, 2011                |  | 1 Year    |         |  | Years |   |         | Years |  |   | 5 Years |  |  | Total |      
|                                                         |  |           |         |  |       |   |         |       |  |   |         |  |  |       |      
|Time deposits                                            |  | $         | 135,711 |  |       | $ | 90,269  |       |  | $ | 26,151  |  |  | $     | 0    
|Securities sold under agreement to repurchase            |  |           | 18,132  |  |       |   | 0       |       |  |   | 0       |  |  |       | 0    
|FHLB borrowings                                          |  |           | 28,750  |  |       |   | 32,750  |       |  |   | 13,000  |  |  |       | 2,000
|Commitments to grant loans1                              |  |           | 5,703   |  |       |   | 0       |       |  |   | 0       |  |  |       | 0    
|Commitments to fund loans for secondary market mortgages |  |           | 1,311   |  |       |   | 0       |       |  |   | 0       |  |  |       | 0    
|Unfunded commitments on lines of credit1                 |  |           | 47,445  |  |       |   | 0       |       |  |   | 0       |  |  |       | 0    
|Purchase obligations of loan participations1             |  |           | 8,000   |  |       |   | 0       |       |  |   | 0       |  |  |       | 0    
|Financial standby letters of credit1                     |  |           | 789     |  |       |   | 0       |       |  |   | 0       |  |  |       | 0    
|Performance standby letters of credit1                   |  |           | 4,370   |  |       |   | 0       |       |  |   | 0       |  |  |       | 0    
|Purchase and building commitments                        |  |           | 6,080   |  |       |   | 0       |       |  |   | 0       |  |  |       | 0    
|Commitment for investment in real estate venture         |  |           | 180     |  |       |   | 0       |       |  |   | 0       |  |  |       | 0    
|Operating lease obligations                              |  |           | 187     |  |       |   | 305     |       |  |   | 189     |  |  |       | 2,394
|Capital lease obligations                                |  |           | 108     |  |       |   | 406     |       |  |   | 290     |  |  |       | 0    
|                                                         |  | $         | 256,766 |  |       | $ | 123,730 |       |  | $ | 39,630  |  |  | $     | 4,394



1The Corporation does not expect all of the commitments
and letters of credit to be fully funded. The total commitments amount related to these contractual obligations does not necessarily
represent future cash requirements.



Critical Accounting Estimates



The Corporation has chosen accounting policies
that it believes are appropriate to accurately and fairly report its operating results and financial position, and the Corporation
applies those accounting policies in a consistent manner. The Significant Accounting Policies are summarized in Note 1 to the consolidated
financial statements included in the 2011 Annual Report on Form 10-K. There have been no changes to the Critical Accounting Estimates
since the Corporation filed its Annual Report on Form 10-K for the year ended December 31, 2011.



Item 3. Quantitative and Qualitative Disclosures about Market
Risk



There have been no material changes in the
Corporation’s quantitative and qualitative market risks since December 31, 2011. The composition of rate sensitive assets
and rate sensitive liabilities as of June 30, 2012 is very similar to December 31, 2011. For more information, please refer to
Part II - Item 7A of the Corporation’s Annual Report on Form 10-K for the year ended December 31, 2011.



Item 4. Controls and Procedures



| | a) | Evaluation of Disclosure Controls and Procedures. First Keystone Corporation maintains disclosure controls and procedures (as
defined in Rule 13a-15(e) under the Securities Exchange Act of 1934, as amended) designed to ensure that information required to
be disclosed in the reports that the Corporation files or submits under the Securities Exchange Act of 1934 is recorded, processed,
summarized and reported within the time periods specified in the rules and forms of the Securities and Exchange Commission. Based
upon their evaluation of those disclosure controls and procedures performed as of the end of the period covered by this report,
the Chief Executive Officer and Chief Financial Officer of the Corporation concluded that the Corporation’s disclosure controls
and procedures were effective as of June 30, 2012.
| | -- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | b) | Changes in internal control over financial reporting. There were no changes in the Corporation’s internal control over
financial reporting during the fiscal quarter ended June 30, 2012, that materially affected, or are reasonably likely to materially
affect, the Corporation’s internal control over financial reporting.
| | -- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------





42







PART II - OTHER INFORMATION



Item 1.	Legal Proceedings



Although the Corporation is subject to various claims
and legal actions that occur from time to time in the ordinary course of business, the Corporation is not party to any pending
legal proceedings that management believes could have a material adverse effect on its business, results of operations, financial
condition or cash flows.





Item 1A.	Risk Factors



| |  | There have been no material changes to the risk factors disclosed in Item 1A “Risk Factors” in the Corporation’s
Annual Report on Form 10-K for the year ended December 31, 2011.
| |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------





Item 2.	Unregistered Sales of Equity
Securities and Use of Proceeds



|Period                           | (a)
        Total Number of Shares Purchased | (b)
        Average Price Paid per Share | (c)
        
        Total Number of Shares Purchased as Part
        of Publicly Announced Plans or Programs | (d)
        
        Maximum Number of Shares that May Yet Be
        Purchased Under the Plans or Programs
|-------------------------------- | -------------------------------------------- | ---------------------------------------- | ------------------------------------------------------------------------------------------------------------- | -----------------------------------------------------------------------------------------------------------
|April 1 —
        April 30, 2012 | —                                            | —                                        | —                                                                                                             | 120,000                                                                                                    
|May 1 —
        May 31, 2012     | —                                            | —                                        | —                                                                                                             | 120,000                                                                                                    
|June 1 —
        June 30, 2012   | —                                            | —                                        | —                                                                                                             | 120,000                                                                                                    
|Total                            | —                                            | —                                        | —                                                                                                             | 120,000                                                                                                    



Item 3.	Defaults Upon Senior Securities



None.



Item 4.	Mine Safety Disclosures



Not applicable.



Item 5.	Other Information



None.





43







Item 6.	Exhibits and Reports on Form
8-K



(a) Exhibits required by Item 601 Regulation
S-K



|               |                                                                                                                                                                              
|-------------- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit Number | Description of Exhibit                                                                                                                                                       
|               |                                                                                                                                                                              
|3i             | Articles of Incorporation, as amended.                                                                                                                                       
|               |                                                                                                                                                                              
|3ii            | By-Laws, as amended and restated (Incorporated by reference to Exhibit 3(ii) to the Registrant’s Report on Form 8-K dated January 14, 2011).                                 
|               |                                                                                                                                                                              
|10.1           | Supplemental Employee Retirement Plan (Incorporated by reference to Exhibit 10 to Registrant’s Report on Form 10-Q for the quarter ended September 30, 2005).                
|               |                                                                                                                                                                              
|10.2           | Management Incentive Compensation Plan (Incorporated by reference to Exhibit 10 to Registrant’s Annual Report on Form 10-K for the year ended December 31, 2010).            
|               |                                                                                                                                                                              
|10.3           | Profit Sharing Plan (Incorporated by reference to Exhibit 10 to Registrant’s Report on Form 10-Q for the quarter ended September 30, 2006).                                  
|               |                                                                                                                                                                              
|10.4           | First Keystone Corporation 1998 Stock Incentive Plan (Incorporated by reference to Exhibit 10 to Registrant’s Report on Form 10-Q for the quarter ended September 30, 2006). 
|               |                                                                                                                                                                              
|14             | First Keystone Corporation Directors and Senior Management Code of Ethics (Incorporated by reference to Exhibit 14 to Registrant’s Report on Form 8-K dated January 9, 2007).
|               |                                                                                                                                                                              
|31.1           | Rule 13a-14(a)/15d-14(a) Certification of Chief Executive Officer.*                                                                                                          
|               |                                                                                                                                                                              
|31.2           | Rule 13a-14(a)/15d-14(a) Certification of Chief Financial Officer.*                                                                                                          
|               |                                                                                                                                                                              
|32.1           | Section 1350 Certification of Chief Executive Officer.*                                                                                                                      
|               |                                                                                                                                                                              
|32.2           | Section 1350 Certification of Chief Financial Officer.*                                                                                                                      
|               |                                                                                                                                                                              
|101.INS        | XBRL Instance Document.*                                                                                                                                                     
|               |                                                                                                                                                                              
|101.SCH        | XBRL Taxonomy Extension Schema Document.*                                                                                                                                    
|               |                                                                                                                                                                              
|101.CAL        | XBRL Taxonomy Extension Calculation Linkbase Document.*                                                                                                                      
|               |                                                                                                                                                                              
|101.DEF        | XBRL Taxonomy Extension Definition Linkbase Document.*                                                                                                                       
|               |                                                                                                                                                                              
|101.LAB        | XBRL Taxonomy Extension Label Linkbase Document.*                                                                                                                            
|               |                                                                                                                                                                              
|101.PRE        | XBRL Taxonomy Extension Presentation Linkbase Document.*                                                                                                                     





*Filed herewith.



The Corporation will provide a copy of any exhibit upon receipt
of a written request for the particular exhibit or exhibits desired. All requests should be addressed to the Corporation’s
principal executive offices.





44







FIRST KEYSTONE CORPORATION





SIGNATURES





Pursuant to the requirements of the Securities
Exchange Act of 1934, the Registrant has duly cause this report to be signed on its behalf by the undersigned, thereunto duly authorized.





FIRST KEYSTONE CORPORATION

Registrant





August 8, 2012	                                                                                                                      /s/ Matthew P. Prosseda

Matthew P. Prosseda

President and Chief Executive Officer

(Principal Executive Officer)







August 8, 2012	                                                                                                                      /s/ Diane C.A. Rosler

Diane C.A. Rosler

Senior Vice President and Chief Financial
Officer

(Principal Accounting Officer)





45









INDEX TO EXHIBITS



|Exhibit | Description                                                                                                                                                                  
|------- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|        |                                                                                                                                                                              
|3i      | Articles of Incorporation, as amended.                                                                                                                                       
|        |                                                                                                                                                                              
|3ii     | By-Laws, as amended and restated (Incorporated by reference to Exhibit 3(ii) to the Registrant’s Report on Form 8-K dated January 14, 2011).                                 
|        |                                                                                                                                                                              
|10.1    | Supplemental Employee Retirement Plan (Incorporated by reference to Exhibit 10 to Registrant’s Report on Form 10-Q for the quarter ended September 30, 2005).                
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|10.2    | Management Incentive Compensation Plan (Incorporated by reference to Exhibit 10 to Registrant’s Annual Report on Form 10-K for the year ended December 31, 2010).            
|        |                                                                                                                                                                              
|10.3    | Profit Sharing Plan (Incorporated by reference to Exhibit 10 to Registrant’s Report on Form 10-Q for the quarter ended September 30, 2006).                                  
|        |                                                                                                                                                                              
|10.4    | First Keystone Corporation 1998 Stock Incentive Plan (Incorporated by reference to Exhibit 10 to Registrant’s Report on Form 10-Q for the quarter ended September 30, 2006). 
|        |                                                                                                                                                                              
|14      | First Keystone Corporation Directors and Senior Management Code of Ethics (Incorporated by reference to Exhibit 14 to Registrant’s Report on Form 8-K dated January 9, 2007).
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|31.1    | Rule 13a-14(a)/15d-14(a) Certification of Chief Executive Officer.*                                                                                                          
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|31.2    | Rule 13a-14(a)/15d-14(a) Certification of Chief Financial Officer.*                                                                                                          
|        |                                                                                                                                                                              
|32.1    | Section 1350 Certification of Chief Executive Officer.*                                                                                                                      
|        |                                                                                                                                                                              
|32.2    | Section 1350 Certification of Chief Financial Officer.*                                                                                                                      
|        |                                                                                                                                                                              
|101.INS | XBRL Instance Document.*                                                                                                                                                     
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|101.SCH | XBRL Taxonomy Extension Schema Document.*                                                                                                                                    
|        |                                                                                                                                                                              
|101.CAL | XBRL Taxonomy Extension Calculation Linkbase Document.*                                                                                                                      
|        |                                                                                                                                                                              
|101.DEF | XBRL Taxonomy Extension Definition Linkbase Document.*                                                                                                                       
|        |                                                                                                                                                                              
|101.LAB | XBRL Taxonomy Extension Label Linkbase Document.*                                                                                                                            
|        |                                                                                                                                                                              
|101.PRE | XBRL Taxonomy Extension Presentation Linkbase Document.*                                                                                                                     





*Filed herewith.



The Corporation will provide a copy of any exhibit upon receipt
of a written request for the particular exhibit or exhibits desired. All requests should be addressed to the Corporation’s
principal executive offices.





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